Readers of the FT over the weekend learned that “a new breed of hedged mutuals grows apace.”  The paper reports that investor demands for liquidity and transparency in hedge funds have forced managers to “try something different.”

But as regular AAA readers are aware, the convergence of hedge funds and mutual funds have been occurring for several years (see end of this post).  In fact, we covered a seminal paper on this subject 3 years ago.  In “Hedge funds for retail investors? An examination of hedged mutual funds” Vikas Agarwal, Nicole Boyson, and Narayan Naik wrote:

“Recently a number of mutual fund companies have begun offering mutual funds that emulate hedge fund strategies, with assets tripling since 2002…over half of the Registered Investment Advisers who do not currently use hedge funds for their clients would add hedged mutual funds to their portfolios.”

The trio concluded that hedge fund managers seemed to be more adept at, well, managing hedge funds:

“…using hedge fund strategies, even within the constraints of the mutual fund environment, can significantly improve performance.”

While “hedged mutual funds” may not be that new, the Madoff Affair may have certainly made them more interesting to retail investors.

A new report by BNY Mellon’s Pershing Prime Services unit and consultancy Finadium (“Competition and Convergence: The Evolving Landscape for Hedge Funds” – available here with free registration) finds that traditional asset managers are adding long/short funds to their line-ups at an astonishing rate.

The companies forecast that the amount of long/short assets managed by traditional money managers will increase by a whopping 75% to $345 billion by 2012.  Meanwhile the amount managed by actual long/short equity hedge fund managers will increase by only 25% to $580 billion.  (Those of you who contend that long-only managers have no business shorting may find this to be further evidence that 2012 will indeed herald the end of the world.)

Back in 2004, Agarwal, Boyson and Nail found that their 39 “hedged mutual funds” (Table 7 of their report) represented about 2% of all hedge funds.  BNY and Finadium find that today, there are 157 such funds managing $27 billion or about 4% of all hedge fund assets (see chart from report below):

But while $27 billion may represent a significant portion of the hedge fund industry, it’s a 0.1% drop in the bucket for the greater mutual fund industry.  In part this seems to have fueled BNY Mellon’s and Finadium’s apparent optimism about the future of long/short mutual funds.  Says the report:

“Soon, long/short mutual funds may very well be a recommended piece of every retail client’s portfolio. Presuming that financial advisors eventually recommend that even 2% of their clients’ assets should be in market-neutral strategies, the equity long/short space could easily grow twenty-fold over the next five years. Given the need for investors to recoup losses sustained in the last year, this recommendation could well make sense.”

Other Similarities

As hedge funds and mutual funds begin to eat each other’s lunch, their leverage levels are also converging.  According to the report (and backed up by several studies we’ve covered here), hedge fund leverage is now almost non-existent – i.e. the same as mutual fund leverage.

Mirroring the industry concentration of the hedge fund sector itself, the top 10 hedged mutual funds manage around two-thirds of all hedged mutual fund assets.  By contrast, the bottom 122 (of 157) funds manages only 10% of all hedged mutual fund assets.

Hedge fund regulation has the potential to increase the speed of convergence.  According to the report, traditional managers felt that “few, if any differences” would remain between hedge funds and traditional managers if hedge funds were to be regulated as investment managers.

Oddly, however, nearly half of traditional managers thought hedge funds were eating their lunch by “institutionalizing” their offerings but hedge fund managers didn’t feel all that threatened by traditional investment managers – citing the usual reasoning that they lack the necessary short selling skills.

So What?

Although long/short funds managed by traditional managers are forecast to grow faster than those actually managed by hedge funds, there remains a significant opportunity for hedgies.  According to the report, hedge funds could partner with traditional managers to launch new products on a sub-advisory basis, and, in effect, leverage the traditional managers’ distribution channels

Considerable risks remain for hedge funds, however.  Chief among them, according to the report is the fact that retail offerings may lead institutional and high net worth investors to believe that hedge funds “…are no longer exclusive enough…”

This is a topic of critical importance to both hedge funds and mutual funds.   As this report and others like it illustrate, it’s not about hedge funds or mutual funds, it’s all about alpha.

Related stories on “convergence” at AllAboutAlpha.com:

2009

• Hedge fund / mutual fund convergence in Europe and the US seen to “mirror” each other
• Financial crisis to slow convergence of hedge funds and private equity, but not for long, says academic
• More evidence of asset management “convergence”

2008

• Hedge Funds and Mutual Funds: Not such an odd couple – as long as conflicts of interest are managed
• “Convergence” gets another shot in the arm from recent calamities
• January turmoil has “sharpened the argument for the convergence of traditional and alternative asset management”: Report
• 130/30 “not monolithic” but does represent a “convergence” in money management

2007

• Convergence at The Rockefeller Center
• “The more we get together, together, the happier we’ll be…”
• Hedge funds for retail investors? An examination of hedged mutual funds
• 2007: Year of Hedge/Mutual Fund Convergence?

2006

• BGI CEO tells FT about “artificial distinction” between hedge and long-only

The cast and crew of AllAboutAlpha.com were in Los Angeles this week meeting with some of our favorite alpha centric asset managers and investment management consultants.  One of those companies was quant manager Analytic Investors.  Regular readers will remember the names Roger Clarke, Harindra de Silva, Steven Thorley and Steve Sapra for their work on extending the “law of active management” and penning a seminal work on short extension (a.k.a. 130/30) strategies.

Clarke, de Silva and Thorley were at it again this year with the release of a very interesting “monograph” (translation: “100 page mini-book”) on alpha/beta separation.  This paper is required reading for anyone with an opinion (either positive or negative) on the somewhat controversial strategy.  With so-called “alpha” allocations producing decidedly beta-like returns the past couple of years, many have discounted the value of delineating alpha from beta in the first place.

As the trio writes:

“The separation of alpha and beta sources of return in institutional portfolios has arrived and is having a profound influence on the way investors view risk and return. Some observers believe that the impact of alpha–beta separation will be as transformative as modern portfolio theory was in the 1960s, while others consider it merely a passing fad. As usual, the truth is probably somewhere in the middle, but the need for a better understanding of alpha–beta principles and terminology among investment professionals is clear.”

Clarke, de Silva and Thorley present a methodical and cogent argument for why alpha and beta should be separated in the first place.  Much of the material on this topic is either too high level (marketing bumpf) or too technical (a lesson on how to execute a swap for beta exposure).  This monograph is a “Goldilocks” description of alpha/beta separation in our opinion.  Those of you who read “Portable Alpha: Theory and Practice” edited by PIMCO’s Sabrina Callin (who was also on our itinerary this week in LA), will find this to be a useful complement to that book.

One of the questions posed to proponents of alpha/beta separation is “Why?”  Why would you even want to separate the alpha and beta that is embedded in every active fund or investment mandate?  This monograph answers this question in a concise, yet sufficiently-detailed manner.

The problem with active management, say the trio is that the ratio of active and passive risk arises organically out of the myriad of separate investment decisions made by the manager.  The resulting ratio may not yield the highest possible Sharpe ratio, however.  In other words, it may be sub-optimal.

For example, assume you owned an actively managed fund with a 0.62 Sharpe ratio.  If you decide to allocate, say, 10% (or even 50%) to cash, you’d have a fund with a lower volatility, a lower return and, of course, the same Sharpe ratio.

But that (unlevered) 50% portfolio – like any actively managed portfolio – is made up of active and passive risk.  It’s essentially made up of a market beta portfolio and a “pure alpha” portfolio.  If you create an efficient-frontier-like line tying together all possible combinations of these two separate funds, you can see that the unlevered fund you began with is really just one arbitrary point on this line.

Unfortunately, it’s not necessarily the point with the highest Sharpe ratio.  Recall that our fund has a Sharpe of 0.62.  But by reallocating between the embedded “alpha fund” and the embedded “beta fund”, you can increase the Sharpe ratio to 0.73 (see chart below from the monograph).

So what?  Well, if you wanted to allocate 90% to the active fund, you could have a 0.62 Shape (“90/10 Mix” above) or a 0.73 Sharpe by allocating 90% to active fund and shorting the market.  The table below corresponds to the chart above:

Like the apparent free lunch served up in an article we covered recently by the rocket scientists at First Quadrant (another stop on our tour of LA this week), Clarke, de Silva and Thorley seem to have pulled a rabbit out of a hat here.  But as they point out, this is simply a logical explanation for the “active risk puzzle” identified by Goldman’s Robert Litterman earlier this decade.  The problem is essentially that active/passive combinations found in active mandates (whether they are of the mutual or hedge variety) leave part of lunch sitting on the table.

There’s plenty more in this paper worth highlighting.  We’ll get to some of it in an upcoming post.

There have been many studies on hedge fund manager return “persistence”.  Persistence, after all, is a necessary precondition for the existence of alpha.  Like alpha itself, you might expect that the persistence of a good Sharpe ratio may be possible in less mature (more informationally inefficient) markets.  But a new study by Siewling Lay, CAIA, finds that this intuition might be wrong.

Special to AllAboutAlpha.com by: SiewLing Lay, CAIA, senior analyst, GFIA

Many investors use the Sharpe ratio conveniently to categorize the risk-adjusted return profile of a hedge fund.  Implicit in its use is the assumption that the fund’s Sharpe ratio is somehow persistent over time – that a good fund manager will stay “good”.  As a result, many investors look to the Sharpe ratio as an indication of how a manager might perform in the future.  If investors decide to include it in their assessments of a fund’s attractiveness for investment, its persistence and reliability would clearly be important.

You might expect that good managers are able to persist in less efficient markets such as emerging markets.  To explore this, my GFIA colleagues and I tested whether in fact Sharpe ratios of Asian hedge funds persisted on a multi-year time frame.  What we discovered might come as a surprise.

Firstly, to ensure that no single fund benefitted from a certain market environment, we examined hedge fund performance over a common timeframe: July 2007 to July 2009 (i.e. not since the inception of each fund).

As you can see from the table below from our report, funds that fall below the 25th percentile show little consistency on a year on year basis.  In fact, only 28% of funds in the top quartile in 2007 actually remained there in 2008:

More…

We’ve read a lot of reports over the past year about how institutional investors are eschewing equities in favour of fixed income and alternative investments. For example, back in February, Pensions & Investments reported:

“Consultants, managers and pension fund executives agree that European pension funds will settle at a much lower equity allocation — unlike the last time, when allocations recovered to previous levels.

In the long term, the allocation to equity will probably settle around 40% (of the total portfolio) rather than around 60%,” said Paul Price, Dublin-based global head of institutional business at Pioneer Investments, which had $213.7 billion in assets under management globally at year-end 2008.”

At around the same time, consultancy Watson Wyatt confirmed this forecast (see chart below from report available here with free registration):

More…

Special to AllAboutAlpha.com by: By Neil Kotecha, CAIA, Vice President, Senior Research Analyst, BNY Mellon Wealth Management

Using risk-adjusted return ratios is a necessary yet difficult task to do when analyzing investment managers. Ranjan Bhaduri points out the weaknesses of the Sharpe ratio in analyzing managed futures products in this July post at AllAboutAlpha.com. However, there are times when market anomalies make using the Sharpe and information ratios difficult even on traditional products. During these times, investors should not use the standard version of these ratios, for they can be misleading and result in ill-informed investment decisions.

Between 1970 and the end of 2008 there have been few periods of extreme losses among US and international equities. The S&P 500 Index’s rolling three-year returns have been positive in all but three periods (1972 – 1975, 1999 – 2003 & 2006 – 2008). Similarly, the MSCI EAFE Index has only had three-year declines in 1972 – 1975, 1989 – 1992, 1999 – 2003 & 2006 – 2008. During these periods, many formulas broke down.

Each of the aforementioned ratios is calculated by dividing a type of excess return by a measurement of risk. As a reminder, the Sharpe ratio uses investment returns in excess of the risk-free rate of return as its numerator, then divides that by the standard deviation of the product (its risk). Similarly, the information ratio uses investment returns in excess of the return of an assigned benchmark as its numerator and then divides that by the tracking error of the product to its benchmark (its risk).

When the investment returns are sufficiently low in both instances, the numerators become negative and the ratios break down. Consider the following examples for the Sharpe ratio, which also apply to the information ratio.

The Sharpe ratio holds when it is positive. Investment A has twice the return and the same volatility so it is preferred over Investment B. …RATIO HOLDS

More…

As the Economist pointed out a couple of weeks ago, the shipping industry has seen better days:

“Since the recession bit hard last autumn a lot of attention has been paid to the plunge in the Baltic Dry Index, a composite measure of the cost of shipping bulk cargoes such as iron ore and coal. It fell by over 90% between June and October last year, although it has since recovered slightly and is hovering at just above a quarter of its peak.”

But although an investment in the shipping industry clearly comes with a boat-load of global growth beta, are there any aspects of this sector that might qualify as an “alternative” investment?

Turns out there may be.  A new article in the Journal of Alternative Investments (available free for a limited time here at the Chartered Alternative Investment Analyst Association’s Website) reveals that shipping actually has some quintessential alternative investment properties.

In “Diversification Properties of Investments in Shipping”, Michael Grelck, Stefan Prigge, Lars Tegtmeier and Mihail Topalov take a more nuanced approach to examining this sector – focusing on shipping companies, not the shipping sector in general.  What they find may be somewhat counter intuitive to most.  Shipping stocks do not have a huge equity beta component.  And as a result, they possess the diversification properties craved by alternative investors.

Report the authors:

More…

Although it is often summarily dismissed by critics, regulation does serve an important role in correcting so-called “market failures” such as economic externalities or asymmetric information.  When a buyer (investor) makes a bad purchase decision, not only do they lose out, but the economy itself suffers from the resulting misallocation of resources (a.k.a. “adverse selection”).

But when regulations stray beyond the bounds of simply fixing these market failures, they too can lead to suboptimal results for buyers (investors) and the economy as a whole.  In other words, the medicine can be worse than the disease.

So goes an argument made recently by Jeff Schwartz in the Spring 2009 George Mason Law Review called “Reconceptualizing Investment Management Regulation“.

“Awkward Response”

Schwartz writes:

More…

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 Performance, Analytics & Metrics…

Debate over value of Sharpe Ratio in HF analysis continues in new academic study
A 2007 academic study rained on the alternative hedge fund metrics parade and claimed that the good old fashioned Sharpe ratio was all you needed.  But another study released this spring suggests that alternative metrics such as the Sortino ratio, Omega ratio and Rachev ratio have a purpose after all.

Investing in some stocks should have qualified as an “extreme sport” says leading quant
Last week, a prominent academic showed how the S&P 500 had become an “extreme” sport before it tanked last year.  This week, that same researcher turns his focus on an individual stock that we know all too well.

Lintner Redux: Omega Ratios and Managed Futures
If only storied academic John Lintner had the Omega Ratio…

2008: The year of the small fund anomaly
Being small and young has always been a virtue in Hedgistan.  But one of these poles reversed in 2008.  Now being big and young seems to produce results.  Too bad it’s virtually impossible to achieve these ends simultaneously any more.

More…

As we learned from Ranjan Bhaduri in a post last week, the non-normal qualities of managed future returns and their low correlation with traditional stock/bond portfolios means that traditional measures such as the Sharpe ratio should be viewed with some suspicion.

While this makes intuitive sense (and certainly seems to be correct when applied to managed futures), other research has suggested that even in cases of non-normality, the old-fashioned Sharpe ratio performs pretty well as a ranking system.  Regular readers will remember this post about a research study by Martin Eling of the University of St. Gallen and Frank Schuhmacher of the University of Applied Sciences and Technology Aachen.  Eling and Schuhmacher found that:

“Despite significant deviations of hedge fund returns from a normal distribution, our comparison of the Sharpe ratio to the other performance measures results in virtually identical rank ordering across hedge funds.”

So much for the Sharpe ratio then, eh?  Well, not so fast…

A study this year by Valeri Zakamouline of the University of Agder in Norway asserts that “the choice of performance measure does influence the evaluation of hedge funds.” (our emphasis)

In fact, contrary to Eling and Schuhmacher, Zakamouline finds that:

More…

(By Ranjan Bhaduri, PhD, CFA, CAIA, Member, AllAboutAlpha.com Editorial Board)  Commodities have always had a reputation for risk, reward and volatility.  Managed futures – a set of strategies aimed at harnessing the return potential of commodities (and of other financial instruments upon which futures contracts are written), has long played a central role in the alternative investment industry.

As you might expect, managed futures have always been more volatile than many of the alternative investment cousins.  But does this mean they serve no role in a diversified portfolio?   Researcher and Harvard professor John Lintner addressed this question back in 1983 in a seminal paper presented at the Annual Conference of the Financial Analysts Federation in Toronto titled “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.”

Firstly, Lintner found the risk-adjusted return of a portfolio of managed futures to be higher than that of a traditional portfolio consisting of stocks and bonds.  But he also observed that portfolios of stocks and/or bonds combined with managed futures showed substantially less risk at every possible level of expected return than portfolios of stocks and/or bonds alone. The following passage from Lintner’s work furnishes good insight on his findings:

More…

One of the great ironies in the hedge fund industry is the propensity for many investors to favor relative returns over absolute returns.  This is particularly true among retail investors who, by and large, would prefer to lose money along with everyone else than to make less than everyone else.  What else could explain the complacency with which investors accept -40% market returns while crying foul at the hedge funds that “under perform” in a bull market.

Research into happiness has dispelled the notion that utility is derived from some absolute level of wealth.  Instead, it appears that utility is relative, not absolute – hence the paradox of the retail investor who is petrified of under performing his neighbours, but sanguine about losing his shirt alongside them.

More than some esoteric argument, the phenomenon of relative wealth may actually account for the overwhelming amount of empirical evidence than seems to refute the hallowed Capital Asset Pricing Model.  In a paper released last month based on his new book “Finding Alpha“, author Erik Falkenstein argues that:

More…

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

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

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

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

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

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

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

More…

In just about every action movie and TV show these days there is at least one scene where the hero asks one of his or her techies to “sharpen” a satellite image.  Suddenly, what looked like a fuzzy bunch of pixelated squares takes on the form of someone’s face, a car, or some kind of mobile rocket launcher.   We’re not graphic imaging specialists.  But to us, it looks kind of outlandish that someone could take a very small amount of information (a few pixels) and divine the underlying image in fantastic detail.

But in a way, that’s exactly what Daniel Li & Michael Markov (of quantitative investment software vendor Markov Processes) and Russ Wermers of the University of Maryland have done in a paper released last month called “Monitoring Daily Hedge Fund Performance When Only Monthly Data is Available.”  Their trick is to leverage another kind of technology: hedge fund replication.

As we have reported extensively, “linear factor replication” aims to predict the performance of hedge funds based on a multiple regression of their historical returns on a number of variables such as equities, Fama/French factors, and several more “exotic” risk factors.

More…