Almost by definition, alternative investments are constantly in a state of flux.  While other disciplines – and even other branches of investment management itself – tend to build upon themselves over time, the alternative investment industry must continually re-evaluate where its been and where it is going.  For us, this requires a focus on new and emerging ideas and an open dialogue that has become synonymous with blogs.  For the Chartered Alternative Investment Analyst (CAIA) Association this requires that its curriculum be constantly re-evaluated and modified.

To that end, the CAIA Association has recently launched its latest curriculum modifications. Beyond being of critical importance for current candidates, these changes are also closely watched by current charter holders and by other professionals as an early indication of which recent industry developments are likely to become an enduring part of the alternative investment landscape.

In today’s guest contribution, the CAIA Association’s Hossein Kazemi discusses one such topic: oil futures.

Special to AllAboutAlpha.com by: Dr. Hossein Kazemi, Program Director, CAIA Association.

Oil is 150 years old.  Exactly 150 years ago Edwin Drake, who was hired by Seneca Oil, drilled a 69.5 feet hole discovering oil in Titusville, Pennsylvania.  Since then, oil has had a profound impact on the world history. Oil is more than a commodity. Numerous wars have been waged to secure it, revolutions have taken place to nationalize it and fortunes have been made and lost producing and trading it.  When oil prices increased by 525% from January 2001 through July 2008, consumers, producers and national governments sought answers and began looking for reasons (scapegoats?) for this sudden rise in oil prices.

Unlike previous episodes of spikes in oil prices where OPEC and other oil producers were blamed by the public and the media, this time speculators in futures market were accused to be the main villain.  It was common to hear that 60% of the rise in the price of oil was due to speculative activities.

In a paper titled “The Oil Markets: Let the Data Speak for Itself” Hillary Till attempts to clear up the misunderstanding and let the data tell the story.  Till argues that fundamental factors (i.e., demand and supply) are much more important to the rise in the price of oil than the behavior of speculators in financial markets. She discusses the opaque nature of the oil markets where accurate estimates of current and potential supplies and demands are not available and therefore price fluctuations are exaggerated because of uncertainty about these fundamental factors. Till acknowledges that transactions in futures market may impact the oil price and drive it away from its fundamental value in the short-run, but she is skeptical about the medium-term impact of these transactions.  Through meticulous research, Till shows that unexpected increases in demand by China, especially leading up to 2008 Beijing Olympics was the primary reason for oil prices reaching $150 per barrel in July 2008.  Till points to the sharp increase in Baltic Dirty Index as evidence that Chinese were importing oil at a very high level in preparation for summer Olympics (See Figure 14 from the text).

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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 Portable Alpha and Alpha/Beta Separation.

Private equity survey may not be all doom & gloom
Despite recent research that suggests otherwise, we may be due for an unexpected boom in private equity beginning sooner than many expect.

“Beta blockers” aim to reduce the blood pressure of those facing hedge fund gates
Stressed about having your money locked up in a hedge fund?  Just pop a few of these…

Portable Alpha to be “reborn” according to author of new paper on the topic
Portable alpha may have died last year.  But according to at least one expert, it’s about to be reborn.

Did Pennsylvania take a wrong turn with portable alpha?
After the announcement by Pennsylvania’s state employees pension plan that it lost money on its portable alpha strategy, some are saying this is proof that portable alpha is “exotic and risky” and that its promoters are “thieves”.  We examine the validity of these claims.

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With the notable shenanigans perpetrated by some hedge fund managers, managed accounts seem like a no-brainer.  After all, who wouldn’t want to be in full control of their own private hedge fund?  You could redeem whenever you wanted, get real time position-level transparency and even do your own valuations.

But as we have suggested in the past, the situation is not quite this simple.  Unfortunately, no managed account is an island.  The legal separation of assets does not sever the fund’s destiny from those of other similar (especially parri passu) managed accounts and funds.  If the managed accounts are not parri passu (for example, if each investor overlays their own risk management rules) then this problem would be solved.  But it would open up another issue: each fund would be different and would have no appropriate track record.

This is one of the points raised in a slide deck being circulated by due diligence company SwissAnalytics.  One of the slides in the presentation (available here at Barclayhedge’s website) contains the following helpful summary of the pros and cons of managed accounts:

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Several recent studies have indicated that the ban on short selling some stocks implemented last fall had a negligible, if not a negative, impact on markets.  Not only did the bans fail to halt the downward slide in stock markets, but they also led to an increase in bid-ask spreads – a sure sign that market liquidity (and thus efficiency) declined.

But one of the ongoing challenges these studies have faced was to determine how much of the post-ban slide in markets was the result of the continuing (and even accelerating) market mayhem and how much might have actually been caused by the bans themselves.  In fact, a new analysis by Abraham Lioui of French research centre Edhec-Risk says that these studies “are unable to disentangle the impact of the ongoing crisis in the financial markets from the impact of the ban on short selling.”

Lioui proposes another approach to “disentangling” the effects of the financial crisis and the effects of the short-bans themselves.  They come to the “odd” conclusion (their description) that equity indices seem to have responded more “strongly and systematically” to the short bans than did the so-called “off-limits” stocks themselves (those where shorting was actually banned).

We summarize Lioui’s conclusion below:

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There seems to be two broad categories of government policy reports on hedge funds over the last few years: those that view hedge funds as self-serving geniuses (example: International Trade Union Congress) and those that view hedge funds as valuable contributors to the global good (example: President’s Working Group).

Naturally, the truth is somewhere in between.  A new report from the International Organization of Securities Commissions (IOSCO) combines both views and paints hedge funds as a sort of self-serving geniuses who happen to contribute to the global good.  The paper was written in response to a call for input from the upcoming London G-20 summit.

Pleasing two masters

As an organization whose members simultaneously count on support from the general public and from hedge funds (whose trading helps fuel their local financial markets), IOSCO has ensured the report has something in it for everyone.  For example, the following excerpts will surely warm the cockles of hedge fund managers’ hearts around the world:

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French business school spin-off Edhec Risk and Asset Management Research Centre is in the business of education.  So it may come as no surprise that a recent white paper by the organization concludes that we all need more education on modern portfolio construction techniques.

While the report ostensibly covers the results of a survey of investment professionals, it does contain a certain element of brow-beating (“practitioners rely mostly on the assumption of a normal distribution…skewness and kurtosis is thus ignored…advanced techniques are not widely used…shortcomings in the area of portfolio construction…“).

However, Edhec makes several valid points about the resistance to measuring higher moments (skew & kurtosis, co-skew & co-kurtosis – see related AAA post) and relative returns vs. absolute returns.  Says the report:

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Critics of hedge fund compensation often argue that hedge fund managers – and by extension, asset managers in general – do not provide a “social good”.  Highly compensated traditional entrepreneurs, they say, make life better for people instead of just shuffling the chairs.

In fairness, it’s not like Obama is encouraging American teens to give back to society by volunteering at their local hedge fund.  No one is encouraging people to “make a difference” by launching a hedge fund and there is no “Hedge Corps” (although there are now many examples of a hedge corpse).  But Edhec’s Arjuna Sittampalam argued earlier this week that hedge funds actually do contribute a social good.  Wrote Sittampalam:

“Amidst all the criticism, there are many aspects in which hedge funds deserve praise. Their strongly pioneering role in venturing into new investment areas, and in the process bringing them to the attention of other investors, is one major aspect. In other ways too, they make a strong social contribution…” (our emphasis)

By “social contribution”, he’s not just talking about hosting society parties in Greenwich either.  Sittampalam is talking about things like Reinsurance, Pulp derivatives, Carbon dioxide emissions credits, Global real estate, including derivatives, Weather derivatives, Credit cards, Higher-risk lending, Socially responsible investments, Film-making and film finance, Catastrophe bonds, Freight derivatives and shipping, Lawsuit funding, Directors’ dealings, Song copyrights and Trade finance.

AIMA CEO Andrew Baker would probably concur with this assessment that hedge funds do provide social good.  As HedgeWeek recently reported:

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EDHEC Alternative Investment Days 2010

Organizer: EDHEC Risk and Asset Management Research Centre
Dates: 8-9 February 2010
Location: The Brewery, London
Agenda: TBA
Speakers: TBA

From Conference Organizer: The EDHEC Alternative Investment Days include two conferences and a roundtable, which will be genuinely significant events for alternative investment professionals:

• the CNBC EDHEC International Herald Tribune Hedge Fund Roundtable of Global Thought Leaders, the theme of which will be “are the new initiatives to regulate the hedge fund industry an appropriate response to the financial crisis?”

• the EDHEC Hedge Fund Summit, which will address four major themes on the basis of new research from EDHEC who will draw the lessons from the financial crisis for the industry:

- How can we assess the financial crisis for the different hedge fund strategies?
- How to capture the operational risks of hedge funds and manage them better? A post-Madoff perspective.
- The role of hedge funds in institutional investment after the financial crisis.
- Why the ban on short sales was not a good idea.

• the EDHEC State-of-the-Art Alternative Investment Conference, which involves the presentation of the research results on the integration of different alternative investment classes or vehicles into asset management and asset-liability management. In 2010, five research projects will be exclusively presented by EDHEC’s professors and researchers and commented upon by alternative investment professionals:

- How to make asset diversification robust in the alternative universe
- ETFs and the alternative asset class
- How to invest in credit derivatives after the crisis
- What will the new forms of investment in commodities be?
- The role of real estate in long-term investment management

In addition to these events, the workshops conducted by the sponsors of the EDHEC Alternative Investment Days will feature their best practices or their research on key themes for alternative investments.
For any additional information on the conference or to enquire about sponsorship opportunities, please contact Vania Schleef by email: vania.schleef at edhec-risk.com or by telephone on +33(0)4 93 18 78 37.

No one will likely be shocked to hear that investors weren’t overjoyed with hedge fund transparency even before the Madoff affair.  This is the headline finding of a survey conducted last fall and released on Friday by French research institute Edhec-Risk Asset Management Research Centre.  But the 72-page study based on the survey of European institutional investors also reveals some more interesting findings.

Hedge fund investors say operational risk reporting is relatively unimportant…

While a wide gap exists between the importance placed on operational risk reporting by hedge fund managers and investors, investors actually value other types of reporting much more than they do operational risk reporting.

The chart below from the report shows that investors are totally unimpressed with current operational reporting.  But note that they also value “operational risk” reporting less than all but one other form of reporting (that being reporting on the manager’s “qualitative outlook”):

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Today, we present several recent news stories that never made it into a post here at AllAboutAlpha.com.  Taken together, they suggest that predicting the future of the hedge fund industry is more complex than some have argued…

Not the end of the line for hedge funds after all?

The reputed demise of funds of hedge funds is exaggerated: Asian Investor reports that “Ironically, the market turmoil coupled with hedge fund implosions and swindles make it an easier task for funds of hedge funds analysts to separate the wheat from the chaff.”

UN fund eyes hedge funds, private equity: Apparently, not everyone is shunning alternative investments…

Returns mark out hedge funds’ stellar performers: The FT recently raises questions about some hedge fund predictions, saying “Several analysts have predicted that the hedge fund industry might not survive this financial crisis. Even George Soros, the billionaire hedge fund manager, predicted late last year that hedge fund assets would fall by 75 per cent.  But funds across a variety of investment strategies managed impressive double-digit returns last year…”

2008 “Hedge Fund 100″: Institutional Investor reports that despite high profile draw downs at large hedge funds, the top 10 aren’t doing too badly after all.  Says the magazine, “Climbing in aggregate to record heights, the world’s ten biggest hedge funds controlled $324 billion in capital, up 29%…”

Hedge fund attrition: How bad?

Hedge funds, battered in ‘08, brace for more pain: Business Week notes that “roughly one in 10 hedge funds will have disappeared last year when final numbers are released in coming weeks.” But what they don’t point out is that this number is pretty unremarkable.  Studies have shown hedge fund attrition to range from 5% to nearly 17% (also see this FAJ piece – Table 7).  The big story from 2008 is that new fund launched were down – not that funds were closing that much more frequently that usual.

(Mutual) Fund liquidations may reach record: You might expect mutual funds to be somewhat more stable.  But according to Investment News, “…359 funds were liquidated last year, compared with 257 in 2007, a 39.6% increase, according to the Denver-based research firm Lipper Inc.”

Hedge Fund AUM Drop: How far?

Hedge fund withdrawals top $269bn in 2008: “…Hedge fund assets fell to $998.4 billion in December 2008 as a result of redemptions and poor performance. In December 2007 assets totalled $1.92 trillion. This is the first time industry assets fell below $1 trillion since July 2004 when they were $976.7 billion.”

Meanwhile, Bloomberg reports that “Hedge-fund assets fell a record 36 percent to $1.84 trillion in 2008 as tumbling global markets prompted investor withdrawals and fund liquidations, according to industry researcher HedgeFund.net.”

Post Madoff marketing, regulation, and industry structure

Hedge Fund Marketing Challenges in the Recessionary, Post-Madoff Environment: “…Today, more than ever, success in attracting investors is dependent upon a hedge fund’s ability to educate and persuade people to be aware of, and buy into, how it invests.”

Fear Of Hedge-Fund Fraud, Meltdown To Spur Debate On Rules: Morningstar reports that hedge fund regulators have traditionally focused on investor protection.  But now “The newer concern has been financial stability.” (Although we notes that it seems one recent $50 billion blow up hasn’t had much of an impact on the financial system.)

2009 Global Asset Management M&A Activity to be Paced by Divestitures, Distress Sales: Hedge fund consolidation to continue, says Putnam Lovell.

Still, “millionaires”, “institutions”, and buyers of hedge fund IPOs licking wounds

Wealthy Wary of Putting New Money in Hedge Funds: The bad news: “Millionaires who long put money with hedge funds are now skittish about adding fresh cash.” The good news: We have probably seen the worst of the [hedge fund industry redemptions]…”

Smart Money Takes a Dive on Alternative Assets: The WSJ’s Jason Zweig cites Larry Seigel’s view that “…Institutions used to rely upon bonds to generate income. But if you sell your bonds to make room in the portfolio for alternative assets, what is left to sell when you need to raise cash for capital calls and to fund your operating budget?”

Investors joining hedge fund club get burned: Buried deep in this article about tanking hedge fund stocks is this light at the end of the tunnel, “Analysts covering Och-Ziff this week cut their profit forecasts, although many also forecast redemptions would ease and that Och’s strong relative performance and reputation would bring investors back.”

Hedge Funds Will Be Ruined by Withdrawal Limits: At least one columnist is really peeved about redemption gates, writing “By forcing investors to keep their money tied up during a bad year, the hedge funds are damaging their own reputation, and it may well never recover.” Problem is that a portion of investors often want their co-investors’ feet held to the fire with theirs.  So managers may be damned if they do and damned if they don’t.

Ponzi. Not since the term “hedge fund” was first used has there been such disagreement over financial terminology.  Suddenly, Ponzi schemes are all over the news.  Forbes’ noted last week in a story called “Everything is Coming up Ponzi” that “authorities are bagging mini-Madoffs left and right.“  Last Thursday, the US government took action against two more “Ponzi schemes” (neither starting with an “M”).  One was allegedly perpetrated by an 82 year old man against elderly members of the Catholic community.   And the other was allegedly orchestrated by a Philadelphia man who convinced investors to part ways with $50 million.

So are these two new Ponzi schemes really Ponzi schemes or is the SEC frantically trying to make up for previous lapses to show that they are back on top of things?

“Little Ponzi’s”

If Time Magazine’s Ari Officer is right then finding Ponzi schemes will be like shooting fish in a barrel for the SEC.  In fact, Officer writes that there is actually a Ponzi scheme in every hedge fund.  The reason is that like all investment funds, hedge funds routinely have a lot of unrealized gains and losses.  The extra challenge faced by hedge funds, however, is that the unrealized gains and losses are locked up in less liquid assets.

As a result, writes Officer, hedge funds sometimes need to rely on new investments to pay out old investors.  After all, why would a fund liquidate a position – particularly one that the manager feels is trading at a discount – when the fund already has a whack of new cash from subscriptions.

In fact, a fund doesn’t even have to do anything wrong to fall under Officer’s broad definition of Ponzi scheme:

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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.

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