Integrating Hedge Funds into a Private Wealth Strategy

Overview Lori R. Runquist Senior Vice President, Director Alternative Investment Strategies Northern Trust Global Investments Chicago Although the roots of the hedge fund industry can be traced back to 1949, hedge funds did not receive much attention until the early 1990s, when managers such as George Soros and Julian Robertson came on the scene. Thus, in 10 years, hedge funds have gone from being a relatively obscure investment strategy to one that investors have a hard time ignoring. But the media coverage on hedge funds has not been all positive. In particular, the collapse of Long-Term Capital Management (LTCM)—a fund that had highly regarded, Nobel Prize-winning associates—has made many investors leery of hedge funds. Historically, hedge funds were used almost exclusively by private clients (although that trend is changing). Thus, because of their importance to private clients, the focus of this conference is the integration of hedge funds into private wealth strategies. The presenters at this conference are both academics and practitioners, and their remarks reflect their extensive knowledge of the industry. I will provide a brief overview of the hedge fund industry and this proceedings.

Industry Size One of the questions that often arise in the popular press and with clients is whether the hedge fund industry is still a cottage industry. By most accounts, the hedge fund arena is somewhere in the vicinity of $600 billion, but no one knows the exact figure. The total investment in hedge funds is compiled in part from information voluntarily reported by hedge fund managers to the hedge fund database providers, such as Hedge Fund Research, Tremont Investment Management, and Van Hedge Fund Advisors International. The problem, as most people know, is that many managers do not report their data. Consequently, the $600 billion figure is extrapolated to a large degree. One of the interesting discussions recently, and something that has been overlooked for a long period of time, concerns the impact of leverage. This $600 billion figure assumes a financial class that does not leverage its assets, which, of course, is not the case. A recent study assumed five times leverage across the entire industry, and based on that assumption, the conclusion was that the hedge fund industry, in fact, ©2004, AIMR®

is not a cottage industry at all. It is worth about $3 trillion. In my opinion, five times leverage across the industry is too high, but even if I assume two and a half times leverage, it is still a $1.5 trillion industry. The size of the industry matters because if the hedge fund arena is no longer considered cottage and is much greater than $600 billion, then if something goes awry, its impact on the financial health of the overall capital market environment will be much greater. That “danger” is one of the reasons that regulators are interested in estimating the size of the industry, including leverage. In 1998, when LTCM blew up, the hedge fund arena was thought to be a cottage industry, yet this event had worldwide impact. The question of the size of the hedge fund industry thus often arises and warrants discussion.

Potential Regulation The press has been reporting for some time that the U.S. SEC is looking into regulating the hedge fund industry. What has come about recently is that, in all probability, the regulators will not change the regulation of standard hedge fund programs, at least not materially. Some minor concessions may take place (e.g., hedge fund managers may have to register as registered investment advisors with the SEC and the SEC may increase the limits in the accredited investor rules), but most players in the industry believe that substantive regulation will not occur. This outlook can be explained in part by the hedge fund industry’s powerful lobbying group, the Managed Funds Association (MFA), which is so powerful that in 1999, following the blowup of LTCM, it managed to thwart a U.S. congressionally proposed bill that was drafted to regulate the hedge fund industry. Other regulations have been proposed through the Commodity Futures Trading Commission and the U.S. IRS, yet this lobbying group has successfully defeated any real regulation, even at a time when the hedge fund industry is thought to be in need of regulation. Therefore, even though the SEC is concerned about potential hedge-fund-related problems, it remains to be seen whether the SEC will institute any major regulatory changes. www.aimrpubs.org • 1

Integrating Hedge Funds into a Private Wealth Strategy

Performance Hedge fund investors (or potential investors) also often inquire about performance. In fact, the question on everyone’s mind in 2003 was whether investing in hedge funds was a good idea given that the equity markets were rallying. Performance is indeed an important discussion point, and this focus on performance, especially by first-time investors, is different from five or six years ago. When the markets are strong, most investors look to hedge funds as a diversification tool in their overall asset allocation. In declining markets, however, investors seek performance. For example, pension fund clients are telling their advisors they cannot meet their actuarial assumptions based on future market projections. Similarly, foundations and endowments are telling their advisors they cannot meet their spending policies unless they find a new added source of return. Likewise, the lifestyle of many high-net-worth investors has been affected to some degree, and many are having to find new ways to generate needed income. For managers of such investors, Douglas Allison and Felix Lin offer their insight on how to present hedge funds to investors and explain the potential role that hedge funds can play in their portfolios. As part of this discussion, Allison and Lin address the pros and cons, the risks and rewards of hedge fund investing. And for investors who decide to go down the hedge fund path, they determine the appropriate portfolio allocation based on expected future returns and use an optimizer to generate an ideal hedge fund strategy mix. Recently, the decision whether to include hedge funds has not been an easy one because the hedge fund environment in the past three years has been the toughest in almost a decade. In fact, in 2002, hedge funds returned the lowest numbers since the databases started tracking the data. Depending on the index used, the return was anywhere from –1 percent to 1 percent, which is considerably lower than the annualized average of 15–18 percent going back to 1990. Indeed, as R. McFall Lamm relates in his presentation, based on Sharpe ratios, 8 of the top 10 investments in the 1990–2002 period were hedge fund strategies. He goes on to discuss other performance characteristics of hedge funds over the past 10 years and even projects performance for 2003 and 2004. But despite their solid past performance, hedge funds do have their critics. Lamm, however, dispels much of this criticism and remains upbeat about the prospects for hedge funds. Nevertheless, one cannot dismiss the lackluster performance of hedge funds in recent years. The reason for the low return, however, is quite interesting; it is a result of the conflux of three events. First, 2 • www.aimrpubs.org

2002 was the lowest interest rate environment in a long time. In the 1990s, those of us in the hedge fund business automatically assumed that good returns were returned by brilliant managers who made exceptional bets on the long side. But we did not appreciate the short interest rebate and its importance to returns. In the hedge fund context, the short interest rebate is income received by the hedge fund manager for every share of stock that he or she is short. Basically, it is an interest payment for collateralizing the short positions. So, if you are a hedge fund manager with any degree of short positions, you have a constant income stream that contributes to your return. Well, in the early years, many of us in the hedge fund industry underestimated the contribution of the short rebate to returns. As an example, for a convertible arbitrage manager in 1997, volatility was much lower compared with today, so for the purposes of this example, assume that the manager had a 30 percent short position. That 30 percent short position generated roughly a 6 percent income stream from the short interest rebate. Welcome to 2002. Now the market is more volatile, so this manager probably has a higher hedge on, which means that about 50 percent of the manager’s capital is tied up on the short side and is now generating only a 1 percent rebate. Therefore, one of the three events that conspired to bring down returns in 2002 (and still continues) was that the interest rate that the short rebate is based on was much lower than usual. The second event has to do with the recent challenges faced by all the strategies lumped under the event-driven category. These strategies make money on events that affect the lifecycles of corporations, such as mergers and acquisitions. The year 2002 saw fewer deals announced, fewer deals closing, more corporate scandals, and less corporate activity. The result, therefore, was a compression of market opportunities in this particular hedge fund sector. The third, and final, event affected hedge fund managers who participate in long–short equity strategies. These managers are stock pickers. Although they are able to hedge on the downside, they still have to pick stocks correctly on the upside. Making correct upside picks in 2002 was difficult for everyone, including hedge fund managers. Thus, the past three years have been the lowest return environment historically for hedge funds. The good news is that because the return drag is being caused by three problems occurring simultaneously, a shift in just one would boost returns. Consequently, I believe that the industry still has a lot of potential opportunity. What we are seeing now should prove to be a temporary short-term performance cycle. ©2004, AIMR®

Overview The long-term picture for hedge funds in relation to other assets is shown in Figure 1. The traditional capital market asset classes are indicated by triangles, individual hedge fund strategies are noted by squares, and the hedge fund composite index (the index used to measure the entire hedge fund industry) is shown with a circle. What comes as a surprise to a lot of people when they see this figure is that hedge funds can generate equitylike returns with bondlike risk. Look at the S&P 500 and the Lehman Brothers Government/Corporate (LBG/C) indexes; numerous hedge fund styles beat the returns of the S&P 500 with lower standard deviation. Some even do so with lower risk than the Lehman index. Something else that comes as a surprise is how many hedge fund substrategies exist and the breadth of all these strategies. When many people think about hedge funds, they think of LTCM, George Soros, and others on the far right side of the figure, where risk, and oftentimes leverage, are concentrated. But the reality is that not much money is on that side of the spectrum anymore, although it used to be. In the late 1980s and early 1990s, that far right side was where most of the capital was deployed. It was speculative; it was global macro; and most investors were high-net-worth investors

who viewed hedge funds as a high-octane strategy. But over time, as more and more institutional participants have entered the market, the majority of the dollars have moved to the left. In fact, a substantial amount of assets in the hedge fund industry is in strategies that have generated returns 5–10 percent better than a diversified bond portfolio but with the same volatility profile. This shift is partly because of the fact that high-octane speculative managers have gone out of business in this difficult market environment and more conservative, plain-vanilla approaches have taken over. So, the average investor probably still views the hedge fund industry as one of the riskiest places to be, but from a volatility standpoint, that perception is no longer true.

Benchmarking Until August 1998 or so, those of us in the business were “hedge fund” managers, and it was sexy to be a hedge fund manager. But within 24 hours of the LTCM blowup, suddenly we became “absolutereturn fund” managers because nobody wanted to be associated with the term “hedge fund” any longer. An absolute return in the late 1990s generally meant

Figure 1. Risk vs. Return of Various Assets, January 1990–December 2002 Return (%) 25

20

Sector Funds Equity Hedge Event Global Macro Distressed Driven Relative Value Debt Fund-Weighted Composite Arbitrage Convertible Market Timing Arbitrage Equity Merger Arbitrage Market Neutral High Yield Statistical Fixed-Income Arbitrage Arbitrage LBG/C

15

10

5

Equity Nonhedge Emerging Markets S&P 500

MSCI World

90-Day T-bills

Short Selling

MSCI EAFE 0

−5 0

5

10

15

20

25

Standard Deviation (%) Source: Based on data from Hedge Fund Research, Inc. Note: Annualized using monthly returns.

©2004, AIMR®

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Integrating Hedge Funds into a Private Wealth Strategy targeting some set figure in any market environment, such as 10 percent for a bondlike alternative and 15 percent for an equitylike alternative. What we learned in the past three years is that we cannot generate 15 percent in just any market environment because of the aforementioned dependency on interest rates. Thus, almost industrywide, a shift is taking place and managers are changing their benchmarks. Absolute return has been redefined. It is no longer a flat 15 percent. It is T-bills or LIBOR plus some premium. Most of the fixed-income alternative programs report using T-bills plus 2 percent, and many of the equity alternatives report using T-bills plus 5 percent or so. Also taking place is a greater shift to peer-group comparisons. In the past three years, many managers have marketed their performance relative to the S&P 500. But hedge funds, particularly absolute-return managers, are not supposed to be compared with a traditional asset class, and thus the S&P 500 should not be the benchmark. Therefore, given some of the confusion around communicating to clients what fund managers’ goals and benchmarks are, we have seen a greater and greater reliance on peer-group comparisons. Thus, fund-of-funds managers typically are using the HFRI Fund of Funds Composite Index, or that of some other provider, to benchmark return performance more appropriately.

Investor Expectations Managing investor expectations has become, to some degree, a greater challenge than it was in the past because discussions are centered on comparative benchmarks, long-term benchmarks, short-term benchmarks, and so on. The result is that the average client does not have a good idea of what to expect out of his or her hedge fund allocation. Richard Grinold faces this issue head-on. He discusses the fact that many investors have investment expectations based on the recent market run-up. But research indicates that the future will not be as bright for the markets. Thus, managers are left with the problem of bridging the gap between what investors expect/need from the market and what the market reasonably will offer. One way he suggests for bridging this gap is to enhance returns by using the law of active management and increasing active management skill and/or breadth. Another way to manage investor expectations is to describe the potential risks (or risk factors) of hedge funds that influence performance. David Hsieh, in work he is carrying out with William Fung, explains that, although the returns and risks of individual hedge funds are highly variable, hedge funds tend to move together in aggregate, and thus, this aggregate performance can be largely explained. Using asset-based style factors, Hsieh shows that the 4 • www.aimrpubs.org

performance of trend-following, merger-arbitrage, fixed-income arbitrage, and equity long–short managers can be explained with some accuracy.

Implementation Issues Clearly, the decision whether to include hedge funds in a portfolio is not an easy one. And once investors have made that decision, the hard work is not over but has only begun. Alexander Ineichen addresses the difficult, but extremely important, task of manager selection. He explains that learning how to identify and choose the best hedge fund managers is an essential part of successful hedge fund investing. As part of the selection process, investors must understand the various types of hedge funds, choose the right approach for their needs and skill level (direct investment or use of a fund-of-funds manager), develop an appropriate asset allocation strategy, and finally, identify the top managers. But the hard work still is not over. Once a manager (or group of managers) has been selected, the investor must conduct due diligence on the manager or managers. Although, as I mentioned previously, hedge funds may be required to file with the SEC, as Joseph Nesler explains, registration does not provide investors with adequate safeguards. The only way for investors in hedge funds to be reasonably secure in their investment is to conduct basic due diligence. He explains that certain qualifications for investing in hedge funds have also been designed to protect investors and then delineates those qualification requirements. Michael Serota considers one of the fine points of the due diligence process—tax impact. He relates how U.S. tax law changes that took effect in 2003 have reduced the marginal income tax rate, long-term capital gains rate, and qualifying dividend income tax rate—all of which have a significant impact on private client investors in hedge funds. But he is quick to point out that the requirements to qualify for the new reduced rates are also important, and depending on the hedge fund’s practices, investors in these funds may or may not qualify for the new rates. Thus, these factors can guide investors in the questions they ask (or should ask) when conducting their due diligence.

Conclusion Hedge funds are, by their nature, complex instruments. They do not fit the mold of traditional asset classes, and yet some hedge funds deliver performance with higher return and lower risk than many traditional asset classes. Investors’ apprehension toward hedge funds is understandable, but so is their desire to invest in them. This dichotomy thus creates significant challenges not only for investors in hedge funds but also for those who are advising them. ©2004, AIMR®

Including Hedge Funds in Private Client Portfolios Douglas T. Allison, CFA Managing Director Beacon Pointe Advisors Newport Beach, California Felix T. Lin Managing Director Beacon Pointe Advisors Newport Beach, California

Hedge funds can play a vital role in client portfolios, but clients need to be aware of all the issues involved—issues ranging from the impact of incorporating hedge funds into the portfolio mix to understanding the potential risks involved to the pros and cons of hedge fund investing. Once the decision has been made to include hedge funds in the portfolio mix, the allocation must be determined and should be based on future expectations for hedge fund performance. Finally, by using an optimizer, an ideal mix of hedge fund strategies can be established. The end result is a portfolio that meets client goals and objectives and has the potential to decrease risk and enhance return.

his presentation begins with a discussion of the role of hedge funds in client portfolios and illustrates how we present hedge funds to our clients. It next relates how we determine the appropriate hedge fund allocation and then continues with a case study in which we determine the allocation to hedge funds. Finally, this presentation ends with a discussion of the optimization process used to determine the hedge fund strategy mix for the case study.

T

The Role of Hedge Funds in Client Portfolios by Felix T. Lin When we make a presentation to clients who are interested in hedge funds, we discuss why they should invest in hedge funds, the various hedge fund styles, how hedge funds have performed, the issues surrounding historical data, the presence of data biases, when use of a fund of funds is warranted, and the overall pros and cons regarding the use of hedge funds.

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Why Invest in Hedge Funds? Hedge funds invest in public market asset classes but typically use alternative investment style management. Thus, they are different from traditional asset classes in many respects. For example, they use limited partnership structures and are allowed more flexibility than traditional managers. They also provide good diversification compared with traditional capital market asset classes, and our optimization models show that they have the potential to decrease overall portfolio risk while enhancing return. Therefore, for all these reasons, we think investors should consider hedge funds.

Hedge Fund Styles Hedge fund styles can be broken into two main groups: directional and nondirectional. The nondirectional styles, such as market neutral, event driven, and arbitrage, are less risky. The higher-risk styles, such as global macro and market long–short, incorporate a more directional approach.

©2004, AIMR®

Including Hedge Funds in Private Client Portfolios Global Macro. This strategy attempts to identify disparities between price and underlying value across a broad range of assets, including specific stocks, stock markets, bonds, currencies, commodities, and real estate. It offers high rewards with high risk because of the use of concentrated positions and leverage to magnify returns. For example, if a global macro hedge fund believes that interest rates in Japan will rise more quickly than interest rates in the United States, this fund will typically go long U.S. T-bonds and short Japanese bonds. Global macro funds thus use a big-picture approach with top-down analysis. Market Long–Short. For equity markets, this strategy uses a portfolio that is either net long or short and that is composed of stocks, options, and other instruments. For fixed-income markets, it uses a net long or short portfolio of bonds, convertibles, and/or other debt instruments. Market Neutral. Market-neutral hedge fund managers purchase securities thought to be undervalued and sell short securities considered overvalued. Some funds limit themselves to specific industries or sectors. Such a fund might be long J.C. Penney Company stock, for example, and short an equal value of Sears, Roebuck and Company stock. So, if J.C. Penney stock rises 20 percent and Sears stock rises 10 percent, the manager makes 10 percent. Similarly, if J.C. Penney stock falls 5 percent and Sears stock falls 10 percent, the manager makes 5 percent. Market-neutral strategies thus balance equal amounts of capital investment in long and short positions in actual securities, options, and/or futures and are, therefore, market neutral. Event Driven. Event-driven strategies focus on special situations. Thus, merger-arbitrage and distressed-securities investing fall within this category. In merger arbitrage, the manager invests in announced corporate takeovers, bankruptcies, spinoffs, divestitures, law suits, and/or other corporate restructurings. In distressed-securities investing, the manager purchases the debt of securities that are in distressed situations and then usually participates in the reorganization or the restructuring of the company.

Arbitrage. Arbitrage covers various strategies. In convertible arbitrage, convertible bonds are hedged with short stock positions. The manager of a convertible bond strategy is seeking to generate returns from the mispricing of embedded options in convertible bonds. For example, if General Motors Corporation’s (GM’s) bonds are convertible into 100 shares of stock, the manager might be long 1 GM convertible bond and short 100 GM shares. If GM shares fall, the shorts will make some money, but if GM shares increase, the bond can be converted into GM stock. Thus, an increase in the stock price causes the value of the convertible to increase but at a disportionately advantageous rate. And by using a short position in the underlying stock, downside risk is effectively neutralized. Fixed-income arbitrage works similarly. If Fannie Mae bonds have higher yields than Treasuries, the manager will try to create an arbitrage opportunity to exploit the higher Fannie Mae yields. With equity arbitrage, the manager attempts to exploit the differences in the intrinsic value of the cash equity market and the corresponding equity derivative market. Currency arbitrage is centered on short-term fluctuations in the relative prices of various currencies.

Hedge Fund Performance When we discuss hedge fund performance with clients, we stress the importance of being long-term investors. That said, we still like to consider our strategic asset allocation as opportunistic. Returns. The annualized returns for a diversified hedge fund portfolio over different time periods have all been positive, unlike the annualized returns for the S&P 500 Index. But fund-of-fund returns have not necessarily beaten the S&P 500, as shown in Table 1. The HFRI Fund Weighted Composite Index returned 12.41 percent during the 10-year period ending July 2003. The HFRI Fund of Funds Composite Index returned 7.93 percent in the same period, and the S&P 500 returned 10.28 percent.

Table 1. Returns through July 2003 Index

1 Quarter

1 Year

3 Years

5 Years

7 Years

10 Years

HFRI Fund Weighted Composite

6.28%

11.58%

4.00%

9.17%

10.74%

12.41%

HFRI Fund of Funds Composite

3.16

6.89

2.99

5.63

7.99

7.93

S&P 500

8.50

10.65

–10.21

–1.06

8.06

10.28

Source: Based on data from Zephyr StyleAdvisor.

©2004, AIMR®

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Integrating Hedge Funds into a Private Wealth Strategy fore, one can see that the downside protection in equities provides hedge funds with their most significant opportunities. The HFRI Fund of Funds Composite had different results. Its upside capture was 31.4 percent and downside capture was –1.4 percent, so it offers better downside protection and less upside capture.

Much of the interest in hedge funds has come about because hedge funds appear to be less risky than stocks. In particular, when the technology bubble burst, many investors started searching for absolute returns. From the second half of 2000 to the second half of 2002, the S&P 500 had significant negative quarters while the HFRI Fund of Funds Composite and the HFRI Fund Weighted Composite performed well because of their absolute-return orientation. This absolute-return orientation motivates many of our clients to pursue hedge funds.

Historical Risk and Return. The historical data on risk and return for hedge funds are interesting. In Table 3, we have broken the basic HFRI data into 1-, 3-, 5-, and 10-year return and risk figures. Note that in the past 10 years, the HFRI short-selling strategy returned 1.25 percent a year, with risk (standard deviation) of 23.22 percent. So, these funds often come with significant risk. During this same 10-year period, the event-driven strategy had the highest return (13.65 percent), and other strategies also performed well.

Upside and Downside. Another performance metric involves estimating upside and downside potential. Table 2 illustrates the upside and downside potential of hedge funds compared with the S&P 500 for the January 1990 to July 2003 period. The HFRI Fund Weighted Composite had upside capture of 55.0 percent and downside capture of 15.9 percent. So, if the S&P 500 is up $1, the HFRI Fund Weighted Composite is up 55 cents. Thus, it is not catching most of the upside, as one would expect. On the downside, however, when the S&P 500 falls $1, the HFRI Fund Weighted Composite is down only 15.9 cents. There-

Correlation. The historical correlations between the hedge fund styles range anywhere from 0.81 for event driven/distressed to –0.80 for long–short/short sellers, as shown in Table 4. The average appears to be about 0.5.

Table 2. Upside and Downside Risk Analysis, January 1990–July 2003 Average Return Index HFRI Fund Weighted Composite

Month

1 Year

Up

Down

Best

Worst

2.08%

–1.40%

7.65%

–8.70%

Best 39.04%

Market Benchmark Upside Capture

Worst –6.41%

55.0%

Downside Capture 15.9%

R2 48.87

HFRI Fund of Funds Composite

1.52

–1.06

6.85

–7.47

33.52

–7.44

31.4

–1.4

17.77

S&P 500

3.59

–3.57

11.44

–14.46

52.14

–26.62

100.0

100.0

100.00

Source: Based on data from Zephyr StyleAdvisor.

Table 3. Historical Risk and Return as of 31 July 2003 1-Year

3-Year

5-Year

10-Year

Index

Return

Risk

Return

Risk

Return

Risk

Return

HFRI Convertible Arbitrage Index

12.63%

3.33%

10.19%

3.06%

11.38%

3.71%

11.21%

3.51%

HFRI Distressed Securities Index

22.01

5.32

10.65

5.39

8.36

7.07

11.74

5.67

HFRI Emerging Markets (Total)

18.37

8.17

6.34

11.81

7.76

17.64

9.86

15.83

0.67

1.56

5.59

3.19

6.58

3.83

8.68

3.37

16.79

5.46

7.33

6.95

9.33

7.97

13.65

6.72

HFRI Equity Market Neutral Index HFRI Event-Driven Index

Risk

HFRI Fixed-Income: Arbitrage Index

7.93

2.10

7.11

2.53

2.90

5.17

6.31

4.26

HFRI Fund of Funds Index

6.89

2.34

2.99

3.30

5.63

7.01

7.93

6.30 8.10

HFRI Macro Index HFRI Merger Arbitrage Index HFRI Short Selling Index CSFB/Tremont Long–Short Index

13.33

7.43

9.44

5.94

8.32

7.09

11.68

5.98

2.09

3.98

3.32

7.96

4.48

11.25

3.74

–10.72

15.18

15.49

23.20

3.11

28.18

1.25

23.22

9.60

4.10

0.96

6.15

9.56

13.22

—

—

Source: Based on data from Zephyr StyleAdvisor and Credit Suisse First Boston Tremont Index LLC.

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©2004, AIMR®

Including Hedge Funds in Private Client Portfolios Table 4. Correlations of HFRI Hedge Fund Styles HFRI Fund Style

Convertible Arbitrage

Distressed

Equity Market Neutral

Event Driven

Fixed Arbitrage

Fund of Funds

Macro

Merger Arbitrage

Short Selling

Convertible arbitrage

1.00

Distressed

0.63

1.00

Equity market neutral

0.24

0.19

Event-driven

0.58

0.81

0.26

1.00

Fixed arbitrage

0.18

0.32

0.08

0.17

1.00

Fund of funds

0.54

0.75

0.29

0.78

0.31

1.00

Macro

0.38

0.51

0.22

0.58

0.18

0.79

Merger arbitrage

0.45

0.53

0.34

0.72

0.02

0.50

0.31

1.00

Short selling

–0.36

–0.56

–0.12

–0.66

0.05

–0.64

–0.43

–0.39

1.00

Long–short

0.43

0.60

0.40

0.72

0.02

0.84

0.68

0.49

–0.80

Long– Short

1.00

1.00

1.00

Source: Based on data from Zephyr StyleAdvisor and Credit Suisse First Boston Tremont Index LLC.

Use of Historical Hedge Fund Data To determine our forecasted returns across strategies, we begin by looking in the rearview mirror. That is, we use past history as an indicator for future performance. We examine performance data for 5- or 10year periods, depending on the investor’s definition of long term. For 5-year rolling periods, the various HFRI hedge fund strategies (including funds of funds) have not generated stable returns, as shown in Panel A of Figure 1. Based on this figure, then, past performance is unstable and should not be used to determine future return assumptions. But rolling 10-year periods of time, as shown in Panel B of Figure 1, show more consistent and more stable returns. Note, however, the decreasing trend in rolling 10-year performance. One explanation for this trend is that the vast amount of assets that has flooded into the hedge fund industry in recent years has led to decreasing arbitrage opportunities and, therefore, decreasing performance. But other issues in the historical data, discussed later, may have also had some influence on the falling return. This trend also means that although studies show that asset allocation in traditional markets explains more than 90 percent of the variability of returns, asset allocation might not be as important in the hedge fund world. In the hedge fund world, the ability to pick good managers within each of the strategies might be more important. Similarly, we also look at standard deviation as a measure of risk. Over five years, again, little consistency exists, as shown in Panel A of Figure 2. But as shown in Panel B, 10-year rolling risk numbers have been stable and more consistent than rolling 5-year numbers. ©2004, AIMR®

Finally, the correlations of these strategies with the S&P 500 over rolling 5-year periods demonstrate volatile results, as shown in Panel A of Figure 3. But when we use 10-year rolling correlations, the results are much more consistent, as shown in Panel B. Again, these data points emphasize the importance of business cycles and remaining invested for long periods of time.

Hedge Fund Data Biases Various biases exist in hedge fund data, namely, selection bias, survivorship bias, backfill bias, and infrequent pricing bias. Selection Bias. Selection bias arises when managers do not submit information to databases. The managers who choose not to submit their data could be either ones with strong performance or ones with poor performance. Managers with poor performance may not want to appear to be inferior to their betterperforming peers and thus may not submit their data. And successful managers with a reliable source of capital and an ideal level of assets under management may not want, or need, any additional business and consequently not see the need to “advertise” their good performance by submitting their data. Thus, no one can judge the caliber of managers who choose not to submit data. So, are these databases a good approximation of reality? It is hard to say. Survivorship Bias. When hedge funds wind up or shut down, some hedge fund databases completely eliminate that fund’s current and historical data. This practice creates survivorship bias in historical fund performance. The assumption underlying this bias is that funds that cease to exist have, as a www.aimrpubs.org • 9

Integrating Hedge Funds into a Private Wealth Strategy Figure 1. Rolling Returns for HFRI Indexes A. 60 Months, 30 November 1994 to 31 July 2003 Total Return (%) 40

30

20

10

0 12/94

12/95

12/96

12/97

12/98

12/99

12/00

12/01

12/02 8/03

11/02

4/03 8/03

B. 120 Months, 30 November 1999 to 31 July 2003 Total Return (%) 22 20 18 16 14 12 10 8 6 12/99

5/00

10/00 Macro

Equity Market Neutral

3/01

8/01

1/02

Event Driven

6/02

Fixed-Income Arbitrage

Fund of Funds

Convertible Arbitrage

Source: Based on data from Zephyr StyleAdvisor.

group, poor historical performance. Thus, taking this group of poor performers out of a category average artificially boosts the category’s track record. Backfill Bias. Backfill bias arises when funds previously not in the database are asked to join the database, perhaps at the request of investors or consultants so that they can make some simple comparisons. Because these funds are not new (just new to the database), they may be allowed to provide all of their historical data from inception, even though they were not part of the database in previous years. Such funds are likely to have above-average performance, thereby creating another upward bias to historical hedge fund returns. Infrequent Pricing Bias. Because many positions held by hedge fund managers are illiquid (i.e.,

10 • www.aimrpubs.org

tough to sell quickly without driving down the price), actual market values for many securities are unavailable. Consequently, asset values are sometimes based on subjective factors. Thus, this infrequent pricing creates a bias in the data that can affect reported performance.

Use of a Fund of Funds We are frequently asked when clients should create their own basket of hedge funds and when they should use a fund of funds. Our general rule is if a client wants to create his or her own basket of hedge funds, the client should have at least $100 million of investable assets to obtain diversification. For clients with a smaller asset base, we recommend using a fund of funds.

©2004, AIMR®

Including Hedge Funds in Private Client Portfolios Figure 2. Rolling Risk for HFRI Indexes A. 60 Months, 30 November 1994 to 31 July 2003 Risk (%) 16 14 12 10 8 6 4 2 12/94

12/95

12/96

12/97

12/98

12/99

12/00

12/01

12/02 8/03

11/02

4/03 8/03

B. 120 Months, 30 November 1999 to 31 July 2003 Risk (%) 10 9 8 7 6 5 4 3 12/99

5/00

10/00 Macro

3/01

8/01

1/02

Event Driven

Equity Market Neutral

6/02

Fixed-Income Arbitrage

Fund of Funds

Convertible Arbitrage

Note: Risk is measured by standard deviation. Source: Based on data from Zephyr StyleAdvisor.

One reason for recommending a fund of funds for smaller investors is that hedge funds are significantly less transparent and less understandable than traditional investments. Consequently, monitoring and evaluating hedge funds requires considerably more resources. Furthermore, investors must diversify their hedge fund investments, and a fund of funds offers this needed diversification. Contrary to what many people think, hedge funds do not exhibit risk that is typical of mutual funds; rather, hedge funds exhibit risk that is more akin to individual securities. Thus, investors need to diversify their hedge fund investments just as they would diversify their investments in individual securities. Fund-of-funds managers also have better access to hedge fund information and data because of their ©2004, AIMR®

industry experience. They know the managers are a closed group, but they still have access to them. In addition, fund-of-funds managers have the resources necessary to investigate the risks of hedge funds. Not only are hedge funds exposed to specific business risk because of the possibility of fraud and the type of leverage they are using; they also contain unknown risks that have not occurred yet in the hedge fund industry. Therefore, for the less sophisticated client with fewer investable assets, we recommend the cautious approach of using a fund of funds.

Pros and Cons The pros of investing in hedge funds are that they offer absolute returns, are uncorrelated with traditional asset classes, provide greater opportunity to www.aimrpubs.org • 11

Integrating Hedge Funds into a Private Wealth Strategy Figure 3. Rolling Correlation of HFRI Indexes with S&P 500 A. 60 Months, 30 November 1994 to 31 July 2003 Correlation 1.0 0.8 0.6 0.4 0.2 0 −0.2 −0.4 12/94

12/95

12/96

12/97

12/98

12/99

12/00

12/01

12/02 8/03

11/02

4/03 8/03

B. 120 Months, 30 November 1999 to 31 July 2003 Correlation 0.8 0.6 0.4 0.2 0 −0.2 12/99

5/00

10/00

3/01

Macro

8/01

1/02

Event Driven

Equity Market Neutral

Fund of Funds

6/02

Fixed-Income Arbitrage Convertible Arbitrage

Source: Based on data from Zephyr StyleAdvisor.

“add alpha,” produce higher returns than fixed income with relatively low market risk, and align managers’ interests with investors’ interests. The cons are that they are subject to little regulation, have low liquidity, are not tax sensitive, have low transparency, contain greater business risk versus traditional investments, impose high manager fees, and require greater due diligence. Both before and after we come up with a final hedge fund implementation for clients, we review these pros and cons with them.

As discussed previously, we use historical data to determine the appropriate allocation to hedge funds so as to meet the client’s specific investment goals or objectives. Before we can determine this allocation, however, we have to understand how hedge fund characteristics are likely to affect the client’s portfolio. That is, because different individuals invest for many different reasons, we have to determine how these characteristics fit into each client’s investment objectives.

Determining the Appropriate Allocation

The characteristics we are concerned with are future expected return, future expected volatility of the return, and future expected correlation of these returns with the other asset classes. To do our analysis, we first look at risk.

by Douglas T. Allison, CFA 12 • www.aimrpubs.org

Performance Characteristics

©2004, AIMR®

Including Hedge Funds in Private Client Portfolios Risk Assumptions. As shown earlier in Panel B of Figure 2, the rolling 10-year risk (as measured by annualized standard deviation) is somewhat consistent. Because of that consistency, we feel comfortable using past historical standard deviation as a proxy or an assumption for future standard deviation for each of the styles of hedge fund investing. Correlation Assumptions. The 10-year correlations, as shown in Panel B of Figure 3, have also been fairly consistent and fairly stable. Again, we feel comfortable using historical correlations as a proxy or an assumption for future correlations. Return Assumptions. The return data are more difficult. As shown in Figure 1, the historical returns have not been consistent. In fact, the 10-year rolling returns have been falling. Furthermore, the databases contain all the aforementioned biases (selection bias, survivorship bias, backfill bias, etc.). Therefore, we cannot use past performance as an assumption for future performance; we have to make another assumption. At Beacon Pointe Advisors, our solution for determining future expected hedge fund returns is to use the capital asset pricing model (CAPM). It is not perfect because using the CAPM also requires making assumptions for excess return, market return, and risk-free return, but it is better than using past data. For each hedge fund style that we are interested in recommending to our clients, we calculate beta. We find that equity market neutral has a low beta of 0.04 relative to the S&P 500, which is to be expected. Fixed-income arbitrage and convertible bond arbitrage also have essentially zero betas. Event driven, which is a combination of merger arbitrage, distressed securities, and other such strategies, has a higher beta of 0.36. Long–short equities have an even higher beta of 0.50, which is to be expected because long–short equity managers are usually directionally long. Thus, as a higher-risk/higher-return strategy, it has some market risk. Finally, we add an excess-return assumption into the CAPM calculation to derive an expected return. Table 5 shows the resulting return and risk assumptions for three general hedge fund styles (market neutral, event driven, and long–short), although we could use this approach to find the return and risk assumptions for all hedge fund styles. Our return assumptions are lower than the historical returns. Therefore, when we do our optimization, the portfolio will have less hedge fund exposure than if we ran the optimization with historical numbers; nonetheless, we are more comfortable with this result than one with a higher hedge fund allocation. ©2004, AIMR®

Table 5. Return and Risk Assumptions Fund Style

Return

Risk

Market neutral

7.04%

Event driven

9.09

6.72

10.98

11.17

Long–short

3.37%

Asset Allocation Once we have an understanding of the various performance characteristics, we can see how hedge funds fit with each client’s investment objectives. The asset allocation depends on the client’s objectives, which then lead to a policy and, in turn, a certain target allocation to each asset class, including hedge funds. Risk and Return Objectives. To determine the best asset allocation to hedge funds, we need to understand clients’ investment objectives. Why are they investing? What are they trying to achieve with their portfolio? And, of course, what are their spending and growth needs? Individuals, even if they have a lot of money, typically want to increase their wealth so that they can give a portion of it to a charity or to the next generation. A client’s risk tolerance is highly dependent on time horizon. With individuals, the investment time horizon depends on their stage in life and certain psychological factors. For example, many individuals believe that a portfolio of hedge funds is more risky than the evidence indicates. In looking at return objectives, higher-return objectives clearly lead us toward hedge funds with higher-return strategies, such as long–short and those with high leverage. The lower-return strategies are market neutral and those with limited or no leverage. Risk tolerance is tied to return. Clients with a higher tolerance for risk will be directed toward higher-risk/higher-return strategies. Such strategies include long–short and those with high leverage, high correlations with other styles, and limited or no transparency. Clients with a lower tolerance for risk will be steered toward the lower-risk strategies, such as market neutral and those with limited or no leverage. These clients will also be directed toward ensuring that they have good diversification (i.e., a large number of funds) because doing so addresses fundspecific risk, which is different from the risk measured by standard deviation and upside/downside risk. Thus, for clients with a low tolerance for risk, we typically recommend having at least 10 hedge funds. If using 10 funds is not possible, we recommend investing in a fund of funds. Constraints. Certain client constraints limit investments or allocations to specific asset classes, including hedge funds. Of course, the investment time www.aimrpubs.org • 13

Integrating Hedge Funds into a Private Wealth Strategy horizon is tied to the risk tolerance because longer (or shorter) horizons will alter the choice of investments within the client’s overall portfolio. Liquidity issues also affect the allocation: Client cash needs vary, and not all hedge fund investments are liquid. Furthermore, certain regulations that generally apply to institutional investors, such as the Prudent Investor Rule and ERISA, can limit the allocation. Taxes are an important consideration when allocating hedge funds to a private client portfolio because hedge funds generally are not tax efficient. Typically, a private client hedge fund investor is in a high tax bracket, so we have to factor in the tax effects. Great risk-adjusted returns that are heavily taxed may not make much sense compared with other taxfree investments. In addition, clients often have unique needs or circumstances that must be considered. For example, some individual investors have social and religious restrictions on their portfolios that limit their ability to invest in hedge funds. Thus, we have to take into account a wide variety of risks, as follows, to see how they constrain the allocation: • Lower level of regulation: Hedge funds’ lower level of regulation can lead to fund-specific risk. Fraud may be involved, and a number of events may cause a portfolio to “blow up” and lose everything. These risks cause us to diversify into multiple hedge fund strategies. For example, we typically do not have an individual investor with only one or two hedge funds in his or her portfolio. • Less or no transparency: Compared with traditional investments, hedge funds have less (or no) transparency. This lack of transparency causes risk—risk that cannot be seen in historical numbers. Unbeknownst to the investor, hedge funds may change their investment process, modify their style, or add more leverage, thereby adding risk to the portfolio.

•

Not tax efficient: Because hedge funds are not tax efficient, we have to limit individual investors’ allocations to hedge funds. • Lack of liquidity: Liquidity issues, discussed earlier, can limit an investor’s allocation to hedge funds. • Complexity of strategies: Individuals do not like to invest a lot of money in strategies they do not understand. They often perceive such strategies to be risky. Thus, their allocation to hedge funds may be constrained. • Greater firm-specific (business) risk: Investors can lose all their money in a hedge fund. It does not happen often, but investors are aware of the possibility. These “headline” risks may cause them to reduce their exposure to hedge funds. • Greater fees: The fees for hedge funds are much greater than those for traditional investments. This higher fee structure can discourage investors from investing in hedge funds. • Potential for leverage to amplify negative returns: Because hedge funds are not transparent, investors do not know how highly leveraged a fund is. This risk causes us to limit the allocation to hedge funds. • Unknown risks: Hedge funds have other risks that we cannot see. Consequently, the existence of these unknown risks alters the allocation. Because of all these risks, we cannot run an optimization model unconstrained. We have to limit the amount of assets put into hedge funds. Result. We ran an optimization model and found that the addition of hedge funds can reduce a client’s portfolio risk and potentially increase its return, as shown in Table 6. In this example, we constrained the allocation to a market-neutral hedge fund to 15 percent. We typically limit the amount of hedge fund exposure to 25 percent for a high-risk investor, so for our average client, the hedge fund allocation is in the range of 10–15 percent.

Table 6. Sample Optimized Portfolio Asset/Measure

Present

Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Portfolio 5

Asset Equity

60.0%

45.0%

49.0%

52.8%

56.5%

60.0%

Fixed income

40.0

40.0

36.0

32.2

28.5

25.0

0.0

15.0

15.0

15.0

15.0

15.0

Market-neutral hedge fund Measure Return (%)

8.46

7.92

8.14

8.34

8.54

8.74

11.73

9.25

9.74

10.22

10.71

11.20

Yield (%)

3.35

3.03

2.91

2.79

2.68

2.57

Sharpe ratio

0.49

0.56

0.56

0.55

0.54

0.54

Standard deviation (%)

14 • www.aimrpubs.org

©2004, AIMR®

Including Hedge Funds in Private Client Portfolios

Summary Hedge funds offer attractive risk–return characteristics. The addition of hedge funds to a portfolio can increase expected return or reduce risk, depending on the client’s goals. Hedge fund allocations, however, should be constrained based on the unique circumstances of the individual. We typically recommend a 10–15 percent allocation with a maximum constraint of roughly 25 percent, depending on the client’s goals and objectives. Hopefully, this presentation provides a better idea of how we, as consultants, introduce hedge funds to our individual clients.

Case Study by Douglas T. Allison, CFA The following case study provides more detail about how we model portfolios that include hedge funds. This case study uses the profile of a typical client who invests in hedge funds. The client is a couple in their late 50s, Mr. and Mrs. Pointe. Both of them are retired, and they have investable assets of about $100 million. They are in a high tax bracket, and their risk tolerance is low. The challenges are to determine (1) the correct allocation to hedge funds for the portfolio and (2) the types of hedge funds to use. To make these decisions, we need to understand why the Pointes are investing and what their investment objectives are. Therefore, we first inquire about their time horizon. Although we know their age, we do not know their investment time horizon unless we ask them. We also ask what their current income needs are. If they have relatively low income needs, they do not need to take a lot of risk and we can focus their portfolio on lower-risk strategies, with both alternative and traditional investments. We then ask if they anticipate any change in their income needs, either up or down. We also ask about their combined federal and state income tax rates. Another important question is whether any circumstances could force an immediate liquidation of a significant portion of portfolio assets. And finally, we ask whether they have any estate planning, legal, or social or religious guidelines. Based on their answers to our questions, we establish an investment policy. The objectives we are trying to achieve for this client are preservation of capital and tax-efficient moderate growth of assets so that the assets can be given to charity and to the next generation after the client’s death. We have also determined that for this client, we want a high allocation to municipal bonds because the client has low income needs and low growth needs, is in a high tax bracket, and does not want to take much risk. Thus, ©2004, AIMR®

we want the traditional investments to be tax efficient, and we want to use low-volatility hedge fund strategies. Essentially, we are not looking to increase their assets significantly, so we are going to lean toward lower-volatility hedge fund strategies. Because this client is in a high tax bracket and has a low risk tolerance, we are recommending that the target allocation to hedge funds be 15 percent of the overall portfolio—a policy decision. Before we optimize the portfolio, we establish this allocation. The reason for this allocation is that hedge funds are tax inefficient and contain fund-specific risk that we cannot control. We want to make sure this is a lowvolatility, low-risk portfolio, so we do not want the total hedge fund allocation to be any higher than 15 percent. Of course, sometimes clients are uncomfortable with a 15 percent hedge fund allocation; they do not understand hedge fund strategies and worry when they see news of hedge funds “blowing up.” In such cases, we set a lower allocation to hedge funds.

Optimization Process by Felix T. Lin For this client, we established the allocation to hedge funds to be 15 percent of total assets. Next, we determine the optimal mix of hedge fund strategies to include in this 15 percent allocation. Most of our clients at Beacon Pointe rely on us to guide them in their decision making. Typically, clients will not tell us that they want 10 percent in this hedge fund, 20 percent in this one, and 5 percent in that one. What they do tell us is that they are conservative, moderate, or aggressive investors. Therefore, we have categorized our hedge fund pools as high risk/high return (aggressive), moderate risk/medium return (moderate), and low risk/low return (conservative). The client in this case study falls into the low-risk/ low-return strategy. We determine the hedge fund style mix within these pools by using mean–variance optimization and the assumptions discussed earlier in this presentation. A model is only as good as its inputs, and we are comfortable with the assumptions we use in our mean–variance model. As we work with clients, we constantly remind them that these assumptions are “best guesstimates,” not concrete facts. Our hedge fund risk profiles are shown in Table 7. As expected, for the low-risk profile, the highest amounts are in convertible arbitrage and equity market neutral. Equity long–short, which is one of the more volatile types of hedge fund strategies, has a lower weighting. This portfolio mix is expected to have a return of 7.84 percent and risk of 2.47 percent. www.aimrpubs.org • 15

Integrating Hedge Funds into a Private Wealth Strategy Table 7. Risk Profiles Style Allocation/Measure

Low Risk

Moderate Risk

High Risk

Style Allocation Convertible arbitrage

25%

20%

Distressed securities

15

10

5

Equity long–short

10

35

60

Equity market neutral

30

15

5

Fixed-income arbitrage

15

10

5

5

10

15

Merger arbitrage

10%

Measure Expected return

7.84%

8.83%

9.81%

Expected risk

2.47

5.14

7.43

The big difference between our low-risk and moderate-risk profiles is that equity long–short becomes 35 percent of the style mix. The expected return of this mix is higher (8.83 percent), as is the risk (5.14 percent), although the risk is still lower than that of traditional equity markets. Finally, for our highrisk profile, equity long–short is 60 percent of the

overall hedge fund mix and equity market neutral is down to 5 percent. Once we have the hedge fund numbers, we look at the client’s present portfolio. For this client, the present mix is 70 percent fixed income in municipal bonds and 30 percent equities. We have recommended adding a 15 percent allocation to hedge funds for this client and then reducing equities to 25 percent and bonds (municipal bonds) to 60 percent. When we plug any of the hedge fund mixes into the overall mean–variance optimization, we lower the overall risk of the portfolio and have the possibility of increasing or enhancing future expected returns, as shown in Figure 4. Therefore, we recommend a 15 percent hedge fund allocation for this client, and we recommend using the moderate-risk profile. By including this hedge fund mix, the client’s overall portfolio has an expected return of 6.95 percent (well above the rate of inflation) with an expected risk of 7.26 percent. Thus, we are meeting the client’s goals—enhancing what the client had previously with a lot less risk.

Figure 4. Efficient Frontier after Adding Hedge Funds Return (%) 7.5 7.3 High Risk

7.1 Moderate Risk 6.9

Present Portfolio

Low Risk

6.7 6.5 6

7

8

9

Risk (%) Note: Risk is being measured by standard deviation.

16 • www.aimrpubs.org

©2004, AIMR®

Including Hedge Funds in Private Client Portfolios

Question and Answer Session Douglas T. Allison, CFA Felix T. Lin Question: For an aggressive investor who wants to maximize growth, would you allocate more than 25 percent to hedge funds? If so, what’s the upper limit? Answer: There is no upper limit to a hedge fund allocation; an allocation depends on the objectives of the individual client. If the client is comfortable with risk and is looking for returns either in excess of what is possible with an all-equity portfolio or that are not correlated with the equity investments currently in his or her portfolio, we could go above 25 percent. But we don’t see that situation often because many of our clients are interested in capital preservation. Although an allocation is entirely based on the individual investor, in general, we don’t recommend allocations of more than 25 percent. We emphasize that there are other risks in hedge funds that don’t show up in the past performance history and that putting in excess of 25 percent in the portfolio could produce something unexpected. Nonetheless, a few of our clients are pushing the 25 percent maximum allocation. But to increase their return (in order to increase their asset growth), instead of increasing their hedge fund allocation, they’ve increased the risk level of their portfolio by, for example, sprinkling in global macro managers or giving a larger allocation to equity long–short managers than that recommended in our conservative, moderate, or aggressive mixes. Again, we express our concerns and emphasize the risk at that level. Question: What percentage of hedge fund return comes from ©2004, AIMR®

asset allocation to individual strategies versus manager selection?

ments moved to a 40–50 percent allocation to hedge funds?

Answer: Our preliminary analysis shows that being in the right style at the right time is not as important as picking the right managers in each style. On the traditional side, you will see bands separating good managers from bad managers, quarter by quarter or year by year. When you look at individual hedge fund strategies, however, there’s a greater variance between good managers and bad managers than on the traditional side. So, on the hedge fund side, we believe that picking good managers is extremely important.

Answer: One reason is that they have a long (almost infinite) time horizon. They also have a lot of money and specific spending needs. It is easy for them to model what they’re looking for because their objectives are clear. Another reason is that they’re looking for absolute returns and don’t like the swings and variability of their asset bases. They’re spending about 5 percent a year, which creates a dramatic drop in their assets. So, they’re looking for more stability as well as returns that traditional asset classes and asset allocation models haven’t given them. In addition, keep in mind that they’re not taxable and can more easily implement a higher allocation to hedge funds.

Question: What role does manager pedigree play in manager selection? Answer: It has a big role. The qualitative factors in selecting a manager are very important. Past returns are only about 25 percent of our process. We evaluate managers based on historical quantitative and qualitative factors. Although quantitative factors are important, what leads to future alpha or future performance are a number of qualitative factors. We break these qualitative factors into the following categories: people and organization, investment philosophy and process, firm or portfolio resources, performance, and fees. Under each main category are a number of subcategories that we use to evaluate and score a manager. This process allows us to understand the strengths and weaknesses of each particular hedge fund or fund of funds. Question: Why have some of the large foundations and endow-

Question: Is your optimization based on pretax assumptions? Answer: When we’re doing a generic optimization, we don’t run it through the after-tax model because each individual has different tax rates. But we do use the after-tax model when we optimize for a specific client. Question: Does the after-tax model significantly change the allocation recommendation from that of the pretax model? Answer: Yes, absolutely. The allocation depends on the tax rate. A high tax rate tends to push a client more toward municipal bonds if the client does not have high growth needs. Question: How do you tame the after-tax data? Are you using index numbers? www.aimrpubs.org • 17

Integrating Hedge Funds into a Private Wealth Strategy Answer: We’re using a model that takes into account the tax rate. And the assumptions that we use are not really index based; they’re assumptions for the future, so there is a relationship with an index, but they are not solely based on the index. As we have shown, we come up with the hedge fund assumptions and then just add on the after-tax model, which takes away the tax from the return and takes into account how tax efficient the strategy is. Question: Which strategies tend to be the most and the least tax efficient? Answer: It varies from manager to manager, but any strategy based on trading heavily creates a lot of short-term gains and is less tax efficient. Thus, a buy-and-hold strategy, which you typically do not see in the hedge fund world, is most tax efficient. It is hard to predict the tax impact going in because these managers have a lot of flexibility in terms of what they can invest in. So, predicting what your taxes will be at the beginning of the year is difficult. We have to use blanket ranges for what we expect tax efficiency to be in the different strategies. We assume these strategies are tax inefficient and that most of the gains will be taxed as regular income. Question: How does measuring risk by standard deviation of return incorporate the risk from leverage? Answer: We look at risk in a number of ways. Standard deviation gives us only the risk that we can incorporate into our optimization model. We constrain the allocation to these hedge fund strategies because of all these other risks, such as leverage, we can’t assume will or will not be there. We can choose low-leverage strategies for a particular investor, but any leverage will increase the 18 • www.aimrpubs.org

risk of the portfolio, even if it hasn’t shown up in the past. Long-Term Capital Management is a perfect example. It had consistent returns and low standard deviation, until it collapsed. We try to make the client understand that other risks are involved with hedge funds, and leverage is one of them. We can’t include it in an optimization program, but it is something you want to keep in mind and limit if you are a low-risk investor. Nevertheless, some hedge funds that you think are low leverage might end up leveraging the fund without your knowledge. Question: Why would you select 10 different hedge funds as opposed to putting the client in a fund-of-funds program? Answer: A fund of funds adds another layer of fees, and you can’t control the allocation of a fund of funds. Although you can pick a fund of funds that meets your objectives, if you have enough money to do your own diversification and to hire an advisor that can do the research, you’re better off. You can pick a group of hedge funds that meets whatever objectives you have. Even 10 funds may not be diversified enough for a client with $100 million, and in that case, a fund of funds would make more sense. The decision is simply a matter of how much diversification you want and how much you want to pay. Question: How do you talk with your clients about the double layer of fees for a fund of funds? Answer: We want our clients to know up front what they’re getting into for a particular program. We’re not trying to push them in any direction. We’re trying to put together a portfolio that meets their needs. So, we let them know what all the risks and fees are up front. We spell out the advantages and

disadvantages of going with a fund of funds versus a direct investment. We don’t like to see a client in one or two hedge funds. That’s just a lot of risk that we can’t control. Question: Doesn’t the reduction in long-term capital gains and the decline in short rebate make it much more difficult to recommend hedge fund exposure for private clients today? Is the only benefit some marginal diversification? Answer: Sure, which is why we limit exposure to hedge funds. Taxes are a major issue with individual investors, so we look at everything after fees and after taxes. Hedge funds are a great diversifier. You can diversify with fixed income, but it is tough to get the returns investors want. So, an individual investor might not want to put all his or her money in hedge funds, but a certain percentage can help the investor meet his or her goals. Essentially, taxes are the reason that clients in high tax brackets do not have hedge fund allocations of more than 20 percent. For the most part, we’re not bringing in hedge funds to be an alpha generator; most clients use hedge funds to diversify assets, not to generate growth in their portfolios. Question: In an attempt to continue to provide outsized returns in a diminishing-return environment, have hedge funds resorted to using increased leverage? Answer: Some hedge funds and funds of funds have not increased the use of leverage. They understand that they need to increase their returns, but at the same time, they are in the business of building their assets, and one thing that has worked against building assets has been the use of leverage. When people hear the word leverage, they automatically think of risk. Many of the managers we talk to have either decreased the amount of leverage ©2004, AIMR®

Including Hedge Funds in Private Client Portfolios or stopped using it because they don’t want that perceived risk when they’re making a business presentation or business pitch. Question: In your presentation, are the return numbers net or gross of fees? Answer: The return numbers are net of fees. Question: Do you have a view on multiple-strategy funds versus single-strategy funds? Answer: A multiple-strategy fund is a lower-risk version of a fund of funds. We’re starting to look more closely at them. But you don’t get the diversification you would in a fund of funds because it is still one organization, one business risk, one philosophy, one group of people. So, you are not as well protected against business risk and unknown risks as you are in a fund of funds if one of the investments goes bad. We like the idea of a multiple-strategy fund because it is a lower-fee version of a fund of funds, but the potential unknown risk factors worry us. Furthermore, multiplestrategy funds usually don’t cover the wide array of funds or investments or strategies that a fund of funds normally covers. They tend to have a specialization, a strength in one area, and are not well diversified. Question: Please address the relative illiquidity and opacity of the absolute-return class of assets. Answer: The illiquidity of any asset class comes into play when considering client objectives, so if a client has spending needs or income needs on an ongoing basis, you have to limit the illiquid investments. If you don’t, the liquid investments become that much more subject to volatility. You could end up in a situation in which the overall portfolio has more risk than you modeled ©2004, AIMR®

because you have to take money from the liquid part of the portfolio to cover the illiquid investments. Question: Panel B of Figure 1 shows a clear downward trend. The period coincides with a dramatic decrease in interest rates. Would you attribute the loss in returns to interest rates or increased efficiency? Answer: We haven’t determined what’s causing this downward trend. It could just be the result of biases in the database. Survivorship bias and so forth would create an upward bias toward the longerterm numbers, but we haven’t determined whether that is the case. It is probably a combination of everything—more money coming into these strategies, survivorship bias and other biases, and the environment. The time period is short; ideally, we’d be looking at these data over 50 or 100 years. We don’t like to make a lot of assumptions based on a 10-year period of time, but that’s all we have in this case. Question: Do you hold your percentages for hedge fund recommendations at 10–25 percent if you also have private equity, or do they come down? Answer: We have to look at the portfolio as a whole. The percentages would come down if we include other alternative investments that are high-risk, highreturn, illiquid strategies. Essentially, our 10–25 percent cap is for all alternatives, not just hedge funds. Question: Why are hedge funds more like stocks than mutual funds? Answer: By definition, hedge funds are more like mutual funds because they are not investing in only one bond or security. Hedge fund managers typically invest in a number of different bonds or securities at one time.

But the volatility and the risk (leverage, business risks from fraud, and other types of risks) of an individual hedge fund are more like the volatility and risk of an individual security. Ultimately, you create a fund of funds or have a diversified basket of individual hedge funds in order to be more like a mutual fund. Think of it this way. A stock has the potential to lose all of its value, just as a hedge fund does. It is rare, but it could happen. In a mutual fund, that would be virtually impossible. Question: How much transparency do you require from your hedge fund managers? Answer: We do not get a lot of transparency, unfortunately. Funds of funds have a better chance of getting transparency from individual hedge fund managers. We prefer to work with funds of funds that have 100 percent transparency, but less than 25 percent of our hedge fund managers give us complete transparency. Question: How often do you report? Answer: We report quarterly, although that is an issue because we typically get data with a longer lag period than that for traditional investments. So, although we report quarterly, it is generally a month after we see the returns for the other investments. Question: What are you using for benchmarks? Answer: It depends on the hedge fund. We like to see an absolute number, especially for marketneutral strategies. If we have a market-neutral strategy, our benchmark would be some alpha over a risk-free return. But for riskier strategies that involve some market risk, such as directional strategies and long–short, we like to see them outperform the S&P 500. www.aimrpubs.org • 19

Integrating Hedge Funds into a Private Wealth Strategy Question: Are you getting better disclosure for your larger institutional clients than for your private clients? Answer: No, there’s not a big difference. Institutions don’t always demand a great deal of disclosure. They look to us for that information. Often, individual investors are more concerned with talking to hedge fund managers than institutions are.

20 • www.aimrpubs.org

Interestingly, institutions have become less interested in talking with investment managers, whether alternative or traditional. They wanted to be involved in the late 1990s, but maybe they got too involved because now they’re leaving that up to the advisor. Question: Do consulting firms have a different fee structure from that of fund-of-funds managers even if the consultant is structur-

ing, in essence, a customized fundof-funds program? Answer: It differs in that funds of funds often charge an upside (1 percent of the committed capital and 20 percent of the profits), whereas advisors, like us, charge an asset-based fee. So, our fee schedule is similar to that of a traditional manager.

©2004, AIMR®

Addressing the Issues and Challenges of Hedge Funds as an Asset Class R. McFall Lamm, Jr. Chief Investment Strategist Head of Global Portfolio Management Deutsche Bank New York City

Hedge funds, although relatively new on the scene, are a viable alternative for investors; they provide attractive return potential with relatively low volatility and low correlations with other asset classes. Although various criticisms have been leveled against hedge funds, only some of them are valid. Thus, the lure of hedge funds remains strong.

edge funds remain one of the best investment alternatives for private investors. Balanced hedge fund portfolios, in particular, provide attractive long-term returns and generally contain no more risk than a diversified portfolio of bonds. In this presentation, I will (1) articulate why hedge funds should be included in portfolios, (2) describe the structure of the hedge fund industry, (3) review hedge fund performance characteristics and the dynamics of managing the hedge fund strategy allocation, and (4) respond to the issues that critics raise in opposition to hedge funds.

H

Hedge Funds as Alternative Investments According to research, asset allocation is the most important component of portfolio performance, and alternative investments are a critical part of progressive asset allocation strategies. In this respect, hedge funds have demonstrated a historically attractive risk–reward ratio in comparison with stocks and bonds, and their inclusion in portfolios has produced superior performance because of their credible diversification benefits. For example, based on historical Sharpe ratios, shown in Figure 1, 8 of the top 10 investments for the 1990–2002 period were various hedge fund strategies. Indeed, from 1990 to 2002, a balanced hedge fund portfolio demonstrated better risk-adjusted returns than any other asset. Furthermore, the liquid-

©2004, AIMR®

ity premium for hedge funds is small compared with private equity and many real estate investments, thus making hedge funds more appropriate for use in the active management of investor portfolios.

Industry Structure According to two recent surveys (one conducted by Deutsche Bank’s prime brokerage desk at the beginning of 2003 and the other by UBS Warburg), highnet-worth individuals hold 60–80 percent of all hedge fund assets and dominate the asset class worldwide. Pensions, endowments, and banks hold the residual. Investors from the United States control 50–70 percent of global hedge fund assets, which is roughly proportionate to the nation’s wealth, and hedge funds of funds represent about 20 percent of the industry, up from practically zero 10 years ago. Not only are hedge funds growing substantially overall, but funds of funds are also expanding and becoming a more important segment of the industry. When comparing the structure of the hedge fund industry in the United States and Europe, a few interesting differences arise. First, European investors are more likely to invest in funds of funds, whereas U.S. investors are more likely to build their own portfolios. Second, European institutions appear to be more open to hedge funds than are U.S. institutions. Finally, because of the large amount of total assets (mostly in stocks and bonds), U.S. institutional commitments to hedge funds appear very small.

www.aimrpubs.org • 21

Integrating Hedge Funds into a Private Wealth Strategy Figure 1. Assets Ranked by Sharpe Ratios, 1990–2002 Sharpe Ratio 1.1 0.9 0.7 0.5 0.3 0.1 0 −0.1 −0.3

Eq

ui

ty

M

ar

ke

tN e D Rot utr is at a cr io l e n C on D tion al is a ve rt M tres ry ib ez s le z ed Eq Ar ani ui bit ne ty ra M er M He ge ge o dg Se r A rtg e ed -S r a ta Sy bit ge ge st rag em e Ve Fi nt A at xe u dre gen ic La In te co C Cap cy rSt T me orp ita ag re A or l e as rb at Ve u it e nt ry rag u B e Ba S m re C ond la nc al a s l B pi ed uy tal V ou Em M ent er ed ure T ts gi iu C IP Ea ng m a S Ea rlyM Bu pita rly Se a y l e -S d C rke ou ta Ve on t D ts ge n v e Ve tur erti bt nt e C bl ur a es e pi C ta a N pit l H AR al ig E h IT Em Y S& iel er P d gi ng S N 50 M ma asd 0 ar ll aq k -C Sh et E ap C or qu s om t S it m el y le od iti EA rs e D s F ol In E la d r I ex nd ex

−0.5

The hedge fund industry is young and in transition, much as the mutual fund business was in the 1960s and 1970s. Ex ante performance benchmarks are only beginning to appear, and an impressive transformation, including structural consolidation and intermediation, is under way. What at one time was a fragmented and dispersed activity is increasingly becoming institutionalized. In the 1990s, investors were largely on their own, seeking out hedge funds scattered around the world to assemble and create their own portfolios. The process was expensive, time consuming, and required an extensive due diligence effort. Today, large institutions increasingly dominate the sell side of the hedge fund business via intermediation by providing funds of funds or by marketing third-party funds. The reason that funds of funds are growing in importance is that they offer three specific benefits to the market. They • reduce the burden on hedge funds to market themselves, • provide investors with easy diversification, and • reduce costs via economies of scale realized from maintaining one due diligence and hedge fund portfolio construction process. For example, investors are now able to obtain due diligence support from numerous financial inter22 • www.aimrpubs.org

mediaries (such as Deutsche Bank). These institutions provide specialized staff who do nothing but analyze hedge funds. Investors receive hedge fund strategy allocation and fund-of-funds management as well as a proprietary database that includes all the funds examined. Deutsche Bank closely monitors about 400 hedge funds and is invested with about 130 of them. Despite ongoing industry consolidation to provide these services, no institution holds more than a 2–3 percent market share, as shown in Figure 2. As the industry matures, further concentration will result in even greater and more sophisticated capabilities provided by institutions.

Performance Characteristics Figure 3 compares hedge fund returns from 1990 to August 2003 with the performance of three-month T-bills, the S&P 500 Index, and T-bonds. To develop the hedge fund composite index in this figure (essentially, an index-of-indexes approach), I used three sources—Evaluation Associates, Hedge Fund Research, and Credit Suisse First Boston/Tremont Investment Management—and calculated an unweighted average of the three. According to this index and the HFRI Fund of Funds Composite Index, hedge fund performance compares favorably with ©2004, AIMR®

Addressing the Issues and Challenges of Hedge Funds as an Asset Class Figure 2. Leading Managers $ Billions 14 12 10 8 6 4 2

M

an

G

U

ro u

p

(R BS MF (G an A dG M Q ue Uni an lenw d o l Pe lo s C n B O’C ood rm a ap nc on ) al ita air no G ro e Pr r) up Cr l M (H edi ana ive au t Su ge e Iv sm iss men a y e A nn Gr t ss et Ho oup Ly N M ldi xo ot an ng r A z S ag s) ss tuc em et k e M i G nt a G r ro na ou sv ge p en m or en Fi G t na ro nc Ci up ia lR tic isk T or M rem p a G nag ont o Bl ldm em e ac ks an nt to Sa D ne ch B A G s bs ro J ol .P. up ut M O e Re org ptim tu an rn C a M St has r o M rga ate e g es n iro St ies w an Fi ley na nc ia l

0

Advisory

Discretionary

Source: Based on data from Institutional Investor, December 2002.

Figure 3. Hedge Fund Returns vs. Other Assets, 1990–August 2003 December 1989 = 100 700 600 500 400 300 200 100 0 90

91

92

93

94

95

96

Hedge Fund Composite HFRI Fund of Funds Composite Index

97

98

99

00

01

02

03

S&P 500 Index T-Bonds

T-Bills

Source: Based on data from Evaluation Associates, Hedge Fund Research, Credit Suisse First Boston/Tremont Investment Management, Datastream, and Deutsche Bank.

©2004, AIMR®

www.aimrpubs.org • 23

Integrating Hedge Funds into a Private Wealth Strategy equities and bonds in terms of both returns and volatility. Thus, it can be said that hedge fund portfolios provide long-term returns comparable to equities, risk comparable to bonds, and low correlations compared with other assets. And unlike stock and bond portfolios, hedge fund portfolios have never had a significant down year. Although it is not perfect, the HFRI Fund of Funds Composite Index is beginning to emerge as an ex ante performance benchmark in terms of the way hedge fund managers, particularly fund-of-funds managers, present themselves. Indeed, if a manager operates a fund of funds and is not beating the HFRI Fund of Funds Composite Index, investors will ask questions. In addition, the index is being used as a more reliable indicator of aggregate hedge fund performance largely because one advantage of using a fund-of-funds index is that most survivorship bias is eliminated, as two academic articles published in 2003 suggest.1 The historical data for a fund-of-funds manager show the returns for all hedge funds that the manager used, whether or not they performed well. Dynamically, then, investors see a real record of performance purged of survivorship bias. Note in Figure 3 how the returns for the HFRI Fund of Funds Com1 Jimmy

Liew, “Hedge Fund Indexing Examined,” Journal of Portfolio Management (Winter 2003):113–123 and Gaurav S. Amin and Harry M. Kat, “Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias over the Period 1994–2001,” Journal of Alternative Investments (Summer 2003):57–73.

posite Index are significantly below the hedge fund composite index. Some of this lower return no doubt arises from the fees that funds of funds charge, but a portion of it is caused by the elimination of survivorship bias, which exists in composite indexes. Finally, note that just as diversification is needed to minimize risk in other investment classes, so too is it needed when investing in hedge funds. For example, investing in only one or a few hedge funds can be very risky, just as investing in only one or several stocks might be. Published research typically indicates that investors should use at least 15–20 hedge fund managers to get the full benefits of diversification. Performance Drivers. My forecasting models indicate that three factors explain 95 percent of the variation in composite hedge fund returns from year to year: credit spreads, equity market performance, and volatility. Changes in credit spreads seem to have an especially dramatic impact on hedge fund returns. Spreads widened sharply during the 1994 Mexican peso crisis, during the 1998 Russian debt default, and in 2002 following the WorldCom scandal. The rotation into the safe haven of government securities during these shocks coincided with weak hedge fund returns, as demonstrated in Figure 4. Some market strategists refer to this relationship as the hedge fund “leap year cycle” because recently credit spreads have been widening dramatically once every four years.

Figure 4. Hedge Fund vs. Credit Spread Returns, 1992–August 2003 Year over Year Return (%) 50 40 Credit Spread

30 20 10

HFRI Fund of Funds Composite 0 −10 −20 92

93

94

95

96

97

98

99

00

01

02

03

Source: Based on data from Datastream and Deutsche Bank.

24 • www.aimrpubs.org

©2004, AIMR®

Addressing the Issues and Challenges of Hedge Funds as an Asset Class Equity market performance and volatility do not correlate as closely with hedge fund returns as do credit spreads, but because long–short equity hedge funds represent a significant portion of the industry, the behavior of equity markets is important. Clearly, hedge fund performance was weak in 2001 and 2002 at the same time equity markets sold off and volatility soared. Obviously, long–short hedge fund managers were affected and this negative impact spilled over into industry composite performance. On the basis of these three factors—credit spreads, equity market performance, and volatility—I predict a good year for hedge funds in 2003. In fact, I was expecting a 5–10 percent return at the beginning of the year, but aggregate hedge fund returns now appear likely to come in at more than 10 percent for 2003. Risk. Despite the market trauma of the past few years, the record shows modest evidence of change in the aggregate risk of hedge fund portfolios. In fact, when the volatility of stocks, bonds, and hedge funds is compared, as in Figure 5, hedge funds exhibit risk comparable to that of bonds. Indeed, the data show a crossover in mid-2002, with bonds now displaying a higher risk than hedge funds. As for correlation, Figure 6 indicates that the 48month rolling correlation between the HFRI Fund of Funds Composite Index and equities is fairly low at about 0.4, although historically it has been somewhat lower and higher at times. Correlations with

other assets are closer to zero. All in all, hedge funds offer significant diversification benefits and can improve the performance of plain-vanilla stock and bond portfolios. Return Outlook in 2003. Most industry experts stratify hedge funds into about a dozen subclasses, as shown in Figure 7, with each strategy having its own risk and return profile. (Note that the short sellers shown in this figure are sometimes listed as one of the equity hedge strategies but with negative beta.) Equity hedge strategies have risen in importance during the past decade and now constitute 38 percent of the market while global macro strategies have declined, although they still represent a 20 percent share, as shown in Figure 8. Based on my strategy return expectations, it now appears that the hedge fund composite should finish 2003 with returns in the low teens. The HFRI Fund of Funds Composite, however, will fall short of composite returns and deliver between 8 percent and 10 percent for the year, barring an equity or credit spread shock. This forecast presumes that • equity markets will rise modestly through yearend 2003; • volatility will hold near 20 percent; • credit spreads will contract but at a reduced pace compared with the first half of 2003; and • short rates will remain flat. The detailed strategy performance numbers and forecasts appear in Table 1.

Figure 5. Hedge Fund, Stock, and Bond Volatility as Measured by Trailing 24-Month Standard Deviation, November 1991–August 2003 Standard Deviation (%) 100

10

1 11/91

3/92

7/94

11/95 S&P 500

3/97

7/98

11/99

3/01

7/02

8/03

Hedge Fund Composite

HFRI Fund of Funds Composite Index

Treasuries

Source: Based on data from Datastream and Deutsche Bank.

©2004, AIMR®

www.aimrpubs.org • 25

Integrating Hedge Funds into a Private Wealth Strategy Figure 6. Trailing Four-Year Correlation of HFRI Fund of Funds Composite Index Returns with Other Assets, 1993–August 2003 Correlation 1.0 0.8 0.6 0.4 0.2 0 −0.2 −0.4 −0.6 −0.8 94

93

95

Bonds

96

97

98

Stocks

99

00

01

Volatility Index of S&P 100 (VIX)

Hedge Fund Composite

02 Cash

Credit Spreads

Figure 7. Hedge Fund Strategies Hedge Fund Universe

Low Risk

Relative Value

Event Driven

Equity Hedge

High Risk

Global Macro

Convertible Arbitrage

Merger Arbitrage

Opportunistic

Systematic

Fixed-Income Arbitrage

Distressed Debt

Long Biased

Discretionary

Rotational

Multi-Event

International

Statistical Arbitrage

Short Sellers

Emerging Markets Sector Technology Biotech Other

■ Relative-value strategies. Convertible arbitrage hedge funds have returned 6.3 percent year to date. I expect at least 7.5 percent by the end of 2003. Returns for fixed-income arbitrage funds are at 4 percent and could reach 6 percent by the end of the

26 • www.aimrpubs.org

year. The equity market-neutral strategy has not done well this year, and for those who understand the strategy, this result comes as no surprise because equity market-neutral managers tend to be long value stocks and short growth stocks. Equity market

©2004, AIMR®

Addressing the Issues and Challenges of Hedge Funds as an Asset Class Figure 8. Asset Distribution among Hedge Fund Strategies, 1999 Fixed-Income Arbitrage 17%

Global Macro 20%

Market Neutral 10%

Event Driven 10% Equity Hedge 38% Other 5%

Table 1. Hedge Fund Performance by Strategy, 1999–2003 Strategy

1999

2000

2001

2002

2003 YTD

2003F

Convertible arbitrage

15.8%

14.9%

11.9%

7.5%

6.3%

Fixed-income arbitrage

11.5

3.0

2.9

4.8

4.0

6.0

Equity market neutral

4.9

10.1

5.9

2.8

0.9

1.6

Merger arbitrage

13.9

15.8

2.9

–2.0

5.1

5.9

Distressed debt

18.3

1.8

15.0

4.8

16.6

18.5

Rotational

21.1

17.7

7.9

2.6

12.9

14.0

Relative value 7.5%

Event driven

Equity hedge Long biased

50.3

4.3

–3.3

–5.5

10.8

13.8

Short sellers

–13.7

26.1

4.8

25.3

–19.2

–21.0

Discretionary macro

10.4

7.8

11.9

7.0

12.9

14.4

Systematic macro

–5.3

6.2

2.2

18.0

8.9

11.2

Hedge fund composite

26.2

6.0

4.0

1.3

9.4

11.5

HFRI Fund of Funds Composite Index

26.5

4.1

2.8

1.0

6.5

9.0

Macro

Exogenous Three-month Treasury

4.7

6.0

4.3

1.8

1.2

1.1

S&P 500

21.0

–9.1

–11.9

–22.1

15.9

21.0

VIX

25.5

25.9

28.0

29.6

26.6

21.0

5.8

7.7

9.0

9.0

6.6

5.4

Credit spreads

Note: 2003 YTD is as of August 2003; 2003F denotes forecasted values.

neutral is simply not the right strategy to use when the equity market is rebounding and investors are rotating into cyclical stocks. ■ Event-driven strategies. Merger arbitrage tends to do well late in the cycle, after equity markets have rebounded and merger and acquisition activity intensifies, which Table 1 bears out. In 1999 and 2000, merger arbitrage performed well, but then equity prices dropped and merger activity dried up, which led to much lower returns in the following years— hitting bottom in 2002 at –2 percent. One should ©2004, AIMR®

clearly avoid this strategy in a down equity market. Distressed debt—which has returned 16.6 percent— has been the best returning strategy so far this year, and I am expecting at least 18.5 percent by the end of the year. The performance of rotational managers is more difficult to predict because they do what the name of the strategy implies: They rotate from strategy to strategy, and one can never be sure where they are. ■ Equity hedge strategies. Equity long-biased managers are having a great year, as should be expected, in response to the equity market rebound. www.aimrpubs.org • 27

Integrating Hedge Funds into a Private Wealth Strategy Short sellers are having an awful year for the same reason. Because the returns of short sellers move inversely with stocks, I recommend caution when including them in a portfolio. Stock prices rise in the long run, so only those investors who are confident in their ability to call the market would want to invest in short sellers. ■ Macro strategies. I believe that global macro managers offer important diversification benefits because they show zero correlation with other market factors except trend momentum. Knowing when to overweight or underweight these funds is difficult because the investor has to be able to predict trending, and even though I can build models that forecast a lot of things well, I have not yet been able to predict when trending will occur. Nonetheless, global macro funds have offered high returns over the years. In fact, systematic macro funds returned 18 percent in 2002. They are the sort of strategy investors want to hold consistently throughout the cycle, except perhaps when equity markets are soaring. Looking forward to 2004. Although it is still too early to make performance forecasts for 2004, investors may want to be cautious in their expectations for hedge fund returns. The reasons for having some reservations are that, first, because of the possibility of an increase in short-term interest rates, the strong equity market of 2003 is unlikely to be replicated in 2004. Second, equity volatility is now running at very low levels and could increase in a rising interest rate environment. Third, although credit spread contraction is likely to continue, much of the adjustment to improving credit quality has already occurred. Fourth, rising short rates will increase the cost of leverage. Fifth, a revitalization of merger and acquisition activity back to bubble levels, including new megamergers, appears unlikely. Another factor to keep in mind is that some hedge fund strategies exhibit asymmetric returns, which is not a big problem for balanced hedge fund portfolios but could spell trouble for hedge fund portfolios with a concentrated strategy exposure.

Strategy Dynamics By examining historical returns since 1989, one can see that the high-return hedge fund strategies are global macro, long-biased equity, and distressed debt, but they achieve their returns at the price of high volatility. The strategies with the lowest longterm returns, the most conservative ones with minimal volatility, include equity market neutral and fixed-income arbitrage. Short sellers, of course, showing only the slightest positive return during the past 13 years, are at the bottom of the rankings. 28 • www.aimrpubs.org

Taking the differential performance characteristics of the various hedge fund strategies into account allows one to see that fund-of-funds portfolio management in many ways is analogous to equity portfolio management. Equity managers organize their portfolios to achieve the right balance among equity sectors. Similarly, fund-of-funds managers must find the correct blend of hedge fund strategies. In addition, manager selection is important for fund-offunds managers just as stock selection is important for equity portfolio managers. The strategy-selection process should be based on current and anticipated market conditions because different hedge fund strategies perform well in various environments. For example, fixed-income arbitrage, convertible arbitrage, and distressed debt are typically sensitive to credit spreads, which tend to contract later in the business cycle. In contrast, long-biased equity managers tend to perform well earlier in the cycle, when stocks normally provide high returns. Other hedge fund strategies are pure alpha generators (such as equity market neutral and global macro) and can deliver results independent of the business cycle. Exploiting this knowledge allows one to manage a hedge fund portfolio strategically to improve returns. But one issue is if a manager is a tactical asset allocator (as I am)—one who rotates fairly frequently among hedge funds, stocks, and bonds—reallocation of hedge fund assets is sometimes a problem. Hedge funds may require up to a quarter for redemption and sometimes longer. In contrast, stock and bond reallocation can be done instantaneously. Nevertheless, hedge funds are generally liquid enough for use in active management, although the process may not be as quick and seamless as desired.2

Criticisms of Hedge Fund Investing Despite the seemingly positive case for investing in hedge funds, some critics continue to raise objections. The most important criticisms are that (1) the data by which hedge fund performance is measured contain survivorship bias and (2) the returns from hedge funds are asymmetric. Besides these two primary concerns, critics also assert that • hedge funds lack transparency; • hedge funds are illiquid; • large capital market inflows are likely to dampen future returns; • hedge funds are not tax efficient for private investors; and 2

See Noël Amenc, Sina El Bied, and Lionel Martellini, “Predictability in Hedge Fund Returns,” Financial Analysts Journal (September/ October 2003):32–46.

©2004, AIMR®

Addressing the Issues and Challenges of Hedge Funds as an Asset Class •

no benchmark is available for performance evaluation. Furthermore, several persistent misconceptions about hedge funds have yet to be adequately dispelled. These include such statements as • arbitrage strategies are nondirectional; • hedge fund returns are largely attributable to alpha generation; and • hedge funds offer absolute returns. In the remaining sections, I will address each in turn. Survivorship Bias. Many articles have exposed survivorship bias in hedge fund performance data and demonstrated that such bias has caused returns to be overstated and risk to be understated.3 The criticism is fair, as far as it goes. Indeed, the raw data provided by distributors tend to drop poorly performing hedge funds. The result is that naive retrospective portfolio optimization often gives a 100 percent allocation to hedge funds and zero to stocks and bonds based on inflated return data. But by using fund-of-funds performance rather than raw data, most of such survivorship bias is eliminated because the records of poorly performing hedge funds cannot be purged from fund-of-funds results. Accordingly, Liew, in his previously mentioned article, supports fund-of-funds data as a benchmark because these data represent what active managers truly deliver. Although some survivorship bias does exist among funds of funds, Amin and Kat (in their previously mentioned article) estimate its magnitude at only 0.6 percent, which is comparable to the survivorship bias of the S&P 500. A comparison of hedge fund composite average annual returns with fund-of-funds returns during the past five years reveals the composite return to be 9.5 percent and the fund-of-funds return to be 7.3 percent, a differential of 2.2 percentage points. This differential reflects the removal of survivorship bias, as well as fees and differences in composition between the composite and fund-of-funds portfolios. Finally, it should be noted that because the performance shown in fund-of-funds data is calculated after fees are assessed, the performance is quite conservative when compared outright with equity and bond index performance, which is calculated before fees and transaction costs. 3 S. Brown, W. Goetzman, and R. Ibbotson, “Offshore Hedge Funds: Survival and Performance, 1989–1995,” Journal of Business (January 1999): 91–117; William Fung and David Hsieh, “Survivor Bias and Investment Style in the Returns of CTAs,” Journal of Portfolio Management (Fall 1997):30–41; B. Liang, “Hedge Funds: The Living and the Dead,” Journal of Financial and Quantitative Analysis (September 2000):309–326; and B. Liang, “Hedge Fund Performance: 1990–1999,” Financial Analysts Journal (January/ February 2001):11–18.

©2004, AIMR®

Asymmetric Returns. As in the case of survivorship bias, it is true that returns for individual hedge fund strategies are asymmetric. Credit spread sensitive strategies, such as fixed income, convertible arbitrage, and distressed debt, show especially strong negative skew and excess kurtosis, thus implying that downside risk exceeds upside potential. But there is little evidence of strong asymmetry in aggregate hedge fund portfolios because skews from different strategies tend to offset one another. My own research indicates that a good hedge fund portfolio manager should blend hedge fund strategies that have negative skew with those that do not or with those that have positive skew. For example, global macro strategies have positive skew because of the way they trade. Global macro managers can, therefore, be blended with negative skew strategies to create a hedge fund portfolio that exhibits an approximately normal return distribution. The question of negative skew should not be a preeminent concern for managers using classical mean–variance strategy allocation. As already noted, the negative skews of some strategies tend to be naturally offset by the positive skews of others. This situation represents a classic example of where the weighted sum of nonnormal distributions results in a distribution that is nearly normal and is illustrated in my recent article in the Journal of Alternative Investments, where I demonstrate a method for constructing positive skew and low kurtosis in hedge fund portfolios.4 Lack of Transparency. Critics often complain about the lack of transparency offered by hedge funds, but this issue is not simply a matter of management willfulness. Hedge funds are legally organized as partnerships, which means that managers are not required to reveal their positions. This structure allows managers to avoid situations in which their positions are made public, which would be a violation of trade secret protection. To force complete transparency via regulation would be, in my opinion, contrary to free enterprise convention. It would also be potentially harmful to existing investors because trading methods would be revealed, which could reduce industry returns. After all, one might argue that at least one reason hedge fund managers can produce excess returns and remain in business is the imperfect state of information, whereby trading activities are not publicly disseminated. From my perspective, I am happy with the transparency now available. I do not understand why investors need any more unless they desire to “free 4

R. McFall Lamm, Jr., “Asymmetric Returns and Optimal Hedge Fund Portfolios,” Journal of Alternative Investments (Fall 2003):9–21.

www.aimrpubs.org • 29

Integrating Hedge Funds into a Private Wealth Strategy fear, of course, is that this process will continue until excess returns are arbitraged away. What this line of thinking fails to consider is that the hedge fund industry is dynamic and evolves as market conditions change. For example, global macro funds were predominant in the early 1990s, but as fixed-rate currency regimes dissolved, returns faded and long–short equity funds became more common. Even now the landscape is changing, and money is flowing into such strategies as distressed debt, convertible arbitrage, and capital structure arbitrage. In addition, for the past four or five years, critics have been warning about limited capacity in the hedge fund industry, and yet supply has increased to meet rising demand. I see no reason that supply cannot continue to expand to match rising future demand. Furthermore, the capacity of some strategies is effectively unlimited, and managers will discover new methods to deliver capacity and profitability. In addition, the hedge fund reward system will continue to attract the best talent from within the asset management industry. Note also that the hedge fund industry possesses expertise found nowhere else. Where else can one obtain proficiency in distressed debt, convertible and fixed-income arbitrage, or global macro management?

ride” by discovering what it is that hedge funds do and want to replicate the approach. If one follows a thorough due diligence process, one can anticipate the likely returns from a strategy and avoid any investment pitfalls. Illiquidity. A certain amount of illiquidity is desirable for hedge funds to operate effectively. In particular, hedge fund managers must be free to control the exit of investors. Otherwise, a flood of redemptions could harm all investors if such positions were forced to be closed all at once. Furthermore, forcing liquidity on hedge funds could potentially allow predators to take offsetting positions in a fund and the market and then allow them to redeem out of the fund to the profit of the predators. One must ask, therefore, why more liquidity should be demanded of hedge fund managers. After all, the managers of other assets, such as leveraged buyout and real estate funds, require lockups for as long as 10 years but face no popular outcry for more liquidity. Effect of Capital Market Inflows. Capital market theory suggests that funds should flow into assets that offer superior risk-adjusted returns—until the excess returns in that sector converge with the others. Such a process may now be under way for hedge funds. Although hard data are lacking, circumstantial evidence, as shown in Figure 9, indicates a downward trend in composite hedge fund returns. The

Tax Efficiency of Hedge Funds. Hedge funds are not tax advantaged in the traditional sense. After all, much of hedge fund income arises from shortterm trading profits and interest income, which are

Figure 9. Year-over-Year Hedge Fund Returns, 1991–August 2003 Year over Year Return (%) 40 35 30 25 20 15 10 5 0 −5 −10 91

92

93

94

95

96

Hedge Fund Composite

97

98

99

00

01

02

03

HFRI Fund of Funds Composite Index Trend Line

Source: Based on data from Deutsche Bank and Hedge Fund Research.

30 • www.aimrpubs.org

©2004, AIMR®

Addressing the Issues and Challenges of Hedge Funds as an Asset Class taxed at ordinary income rates for private investors. Certainly, this result is a negative for taxable investors, but it is of no consequence to ERISA institutions, endowments, many off-shore investors, and some trusts that are exempt from taxes on investment income. For taxable investors, the solution is to simply house hedge fund investments in nontaxable or deferred-tax structures. Doing so transforms the asset “allocation” problem into an asset “location” problem. In a recent article, Bruce Paulson discusses a number of vehicles capable of accomplishing this objective.5 Therefore, to argue against hedge funds because of their tax consequences is to reject tax management outright, a proposition that few investors would accept, including equity portfolio managers who often take tax considerations into account.

debt, and global macro) frequently produce negative returns. Thus, such approaches obviously do not always deliver absolute returns. Finally, Myth 3 is that hedge fund returns are largely attributable to alpha generation and not beta exposure. My research shows exactly the opposite, demonstrating that returns are largely a consequence of underlying market positions and much less the result of ingenious trading capability (alpha). For example, equity long-biased managers appear to have profited over the long run by generally being long small-cap stocks and short large-cap stocks and not by having a magical proficiency to select stocks.6 This approach is fundamentally driven (and very smart) because small caps have historically outperformed large caps.

Persistent Hedge Fund Myths. Three myths about hedge funds remain prevalent. Myth 1 is that some common hedge fund strategies are nondirectional. This argument is usually applied to arbitrage strategies, where returns are immune to general market movements. But this assertion neglects the fact that arbitrage represents a long spread position, which does in fact fluctuate directionally through the business cycle. For example, the performance of fixed-income arbitrage and convertible arbitrage is highly correlated with credit spreads; the performance of merger arbitrage is correlated with merger and acquisition activity; and the performance of equity market-neutral funds is correlated with the relative performance of value versus growth stocks. These strategies all move directionally in response to cyclical forces. Myth 2 is that hedge funds offer absolute returns. Although achieving absolute returns may be the goal of hedge funds, 1998 was a negative-returning year for the industry, and other such negative-returning years could occur in the future. The reality is that balanced hedge fund portfolios simply offer relatively low overall risk and, therefore, rarely deliver negative returns. Furthermore, some of the highervolatility strategies (such as equity hedge, distressed

Conclusion

5

See Bruce L. Paulson, “Integration of Hedge Funds and Wealth Transfer Structures: Where Should They Be and Why?” Journal of Wealth Management (Fall 2003):78–85. Paulson highlights a multitude of ways to accomplish efficient asset location, including deferred compensation, 401(k)s, SWAPS, private placement life insurance, grantor trusts, grantor-retained annuity trusts, charitable lead annuities, and various retirement vehicles.

©2004, AIMR®

Hedge fund portfolios provide attractive long-run returns—low volatility, survivorship bias, and asymmetry notwithstanding. Unlike highly illiquid assets, such as private equity and real estate, hedge funds are sufficiently liquid to be used in active portfolio management. Even for hedge funds with quarterly liquidity, this timing is better than locking money in private equity or real estate partnerships for up to 10 years. All in all, hedge funds allow one to improve portfolio performance and efficiency. The allocation to hedge funds depends on market conditions and the investor’s risk preferences. In particular, the low risk of balanced hedge fund portfolios makes them suitable for conservative investors. A long-term allocation to hedge funds of 20 percent or more is generally prudent for most investors, although some endowment funds have 50 percent allocations and certain private investors have 100 percent allocations. Anything less than a 10 percent allocation will likely have little real impact on portfolio performance. Finally, looking forward, it appears likely that hedge fund portfolios (meaning funds of funds) should deliver near 10 percent in 2003. But the outlook for 2004 is a little less rosy simply because of the fact that the incredible credit spread compression and equity market rebound experienced in 2003 are not likely to continue at the same pace in 2004. 6 See

R. McFall Lamm, Jr., “How Good Are Equity Hedge Managers?” Alternative Investments Quarterly (January 2002):17–26.

www.aimrpubs.org • 31

Integrating Hedge Funds into a Private Wealth Strategy

Question and Answer Session R. McFall Lamm, Jr. Question: Would you comment on using private placement in life insurance structures to improve after-tax return in the United States? Lamm: I am not a tax expert, but one can create vehicles whereby tax is, at a minimum, deferred on hedge fund income. I refer you to the Paulson article, which gives a more detailed description. You should also discuss this issue with the trust and tax experts in your organization.

32 • www.aimrpubs.org

Question: How do you define your credit spreads, and which securities are you using? Lamm: I take credit spreads as an aggressive mixture—high yield to Treasury index spreads. This definition significantly increases the explanatory power of predicting hedge fund returns versus other measures. Also, the emerging market debt to Treasuries spread works well in many instances. I suggest modeling a combination of both high-yield and emerging market debt index spreads over Treasuries.

Question: Doesn’t the limited availability of good fund access imply that large funds of funds will be forced to put money with increasingly weaker managers? Lamm: I think this phenomenon is part of the evolution of the industry. As I indicated, larger institutions with more capability in terms of due diligence and better access to managers, especially closed managers, will tend to perform better. Does this squeeze out the investors who are lower on the totem pole? I believe it may.

©2004, AIMR®

Closing the Gap between Expected and Possible Returns Richard C. Grinold Director, Advanced Strategies and Research Group Barclays Global Investors San Francisco

Investors have return aspirations that are, in part, based on the marvelous investment results of the past 20 years. But the market may not be able to meet those investor expectations over the next 10 years. At Barclays Global Investors, we have an approach for estimating the market return, and that estimate is not promising if investors are anticipating a 10 percent return a year on their investments. To bridge the gap between investor expectations and what the market can offer, investors and active managers must take several steps to enhance returns. One such step is to apply the fundamental law of active management, which entails increasing active management skill and/or breadth.

n this presentation, I will examine the likely returns of U.S. equity markets and global markets over the next 10 years.1 The problem that arises is that what the markets have to offer does not match what many investors expect from the markets. Thus, an expectations gap exists. I will discuss how to bridge that gap and cover some strategies for reducing it— for bringing expectations and offerings closer together.

I

Market Offerings At Barclays Global Investors (BGI), we break down the market according to various instruments that we call bricks, shown in Exhibit 1. We estimate the expected return on each market instrument and then sum the returns. Note that in the examples used in this presentation, I am looking at a 10-year horizon. Exhibit 1 has five components:2 • real rate of interest, • inflation, • a term premium, • a credit risk premium, and • an equity risk premium. 1

Note that the forecasts reported in this presentation were made in September 2003. 2 These components are all expected sources of return; at BGI, we have dropped the qualifier “expected” because it is universally applicable.

©2004, AIMR®

To make matters simple, at BGI, we aggregate these five components into two parts. The sum of the first three (real interest, inflation, and a term premium) we use to obtain an expected return on 10-year U.S. government notes. The last two (the expected credit risk premium and the equity risk premium) we combine and, at the risk of some confusion, still call the equity risk premium.3 This aggregation breaks the market return into two parts—government bonds and equity. Bonds. Our average expected return on the U.S. bond market for the next 10 years is driven primarily by the current state of the bond market and our view on observed nominal interest rates in the next 10 years. BGI’s view of future rates is, we hope, a consensus view from a group of knowledgeable people. As of this writing in September 2003, government bonds are yielding about 4.25 percent. We anticipate that rates in 10 years will be close to an equilibrium level of 5 percent. In other words, we estimate a repricing in the bond market in the next 10 years that will subtract somewhat from the total return for bonds. The net effect gives us an estimated 4 percent return in the U.S. government bond market during 3 In the initial usage, we are thinking of the expected return over and above 10-year corporate bonds, and in the second usage, found throughout the rest of the presentation, we are thinking of the expected return over and above 10-year government bonds.

www.aimrpubs.org • 33

Integrating Hedge Funds into a Private Wealth Strategy Exhibit 1. Decomposing Expected Return into Risk Premiums Expected Equity Risk Premium

Equity Market

Corporate Bonds

Expected Credit Risk Premium

T-Notes

Expected Term Premium Expected Inflation

T-Bills Expected Real Rate of Interest

Implied by TIPS

the next 10 years: 4.25 percent from current yields and –0.25 percent resulting from the anticipated rise in rates to 5 percent over the 10-year period. Equities. Before I dive into our forecasts for the equity markets, please keep in mind that the methodology driving our expected market return is probably more important than the particular numbers. In other words, instilling the discipline to think about the market return as additive building blocks is an important message. Each investor can walk through the same exercise and harness his or her own judgments and insights. The most challenging task is estimating the equity market risk premium. Equity markets are extremely volatile. Figure 1 shows the excess return of stocks over bonds for the previous 10 years starting from the mid-1930s until 2001. The shaded area is centered on the mean (roughly 7 percent) and is adjusted to include two-thirds of the observations; it ranges from about 1 percent to 13 percent. Our goal is to get a fairly precise estimate of the equity risk premium. We would like to say it is something like 4 percent, plus or minus 1.5 percent. If we rely on historical data, we will end up saying it is something like 7 percent, plus or minus 6 percent, which is not good enough. Something more structured is needed. In generating expected equity market returns, we use a simple model that focuses on an income return and a capital gain:4 Stock return = Income + Capital gain.

(1)

The income return is then broken down into two pieces: dividends and net share repurchases: Income = Dividend yield + Share repurchase. 4

(2)

In the interest of clarity, I have dropped the term “expected” from all these sources of return; however, they are all expected returns.

34 • www.aimrpubs.org

Figure 1. Ten-Year Realized Return Spreads of Stocks vs. Government Bonds, 1935–2001 Spread (%) 25 20 15 10 5 0 −5 −10 −15 35

41

47

53

59

65

71

77

83

89

95

01

Source: Based on data from Ibbotson Associates.

In a similar fashion, we separate the capital gain into three pieces: Capital gain = Real earnings growth + Inflation + Repricing.

(3)

The repricing refers to the change in market price/earnings multiple (P/E) over the 10-year period. To determine these five components (dividend yield, share repurchase, real earnings growth, inflation, and repricing), we engage in a great deal of informed speculation; that is, each component is estimated with some degree of uncertainty. Because we are adding these numbers together, the error in the sum depends on the error in the components and is driven by the component with the largest error (sort of like the chain being only as strong as its weakest link). For instance, dividends can probably be estimated within 0.25 percent. And real earnings growth ©2004, AIMR®

Closing the Gap between Expected and Possible Returns is rather straightforward because real earnings growth is quite stable over long periods of time, at around 2 percent accurate to within 0.50 percent.5 Inflation is straightforward as well. Thus, four of these five components are relatively easy to estimate. The largest uncertainty surrounds our estimate of the repricing—our attempt to predict the P/E multiple in 10 years’ time. Will it be at 10, 15, 20, or 25 times earnings in 10 years? To arrive at an answer, a group of people within our firm make, with considerable and frequently animated discussion, a collective estimate on the equity market’s P/E in 10 years’ time. The amount of error in the P/E repricing is ±2 percent. Thus, the noise in the final number for stock return comes primarily from the P/E repricing. Table 1 shows our current views on the components of the equity risk premium for the United States, the United Kingdom, Europe ex United Kingdom, Canada, Australia, and Japan. The critical number is the equity market multiple repricing, and notice the courageous forecasts we have made: We have set the repricing at zero, which means we expect the market P/E to remain at its current level. But keep 5

Anyone interested can further break up earnings growth into the components of labor force growth and productivity growth.

in mind that this number is the one with the most fuzz, the most uncertainty. Notice that Japan is the outlier, with a total expected equity return of 3.75 percent, and that the United States comes in with a value of 8 percent for total expected equity return. One advantage of using this discipline is that it requires a focus on our zones of ignorance—the things we do not know. We use informed speculation rather than uninformed speculation or what some call “wild guesses.” And notice that the methodology can be turned around. If an investor wants to insist that the U.S. equity market will return 11 percent a year for the next 10 years, then this investor can see what that return implies for an end-of-period P/E. To get that extra 3 percent return a year, the P/E would have to increase by about 30 percent (3 percent for 10 years) and go, for example, from 22 to 28.6. Table 1 both summarizes our 10-year forecasts and illustrates our estimation methodology. So, given the numbers in Table 1, how does one start to make investment decisions?

Investor Expectations The first step in making investment decisions is to create a model portfolio for the investor. Peter Bernstein and my coworker Kevin Kneafsey have been

Table 1. Current Views on the Components of the Equity Risk Premium United States

Measure

Europe ex United United Kingdom Kingdom

Canada

Australia

Japan

Income return Dividend yield

2.00

3.50

3.00

2.00

3.25

1.50

Net buybacks

0.50

0.50

0.25

0.75

0.75

0.25

2.50

4.00

3.25

2.75

4.00

1.75

Labor force growth

1.00

0.50

0.25

1.00

1.25

–0.50

Productivity growth

2.25

2.00

1.75

2.00

2.00

1.50

Excess corporate growth

0.25

0.00

0.50

0.00

–0.25

0.50

Total

3.50

2.50

2.50

3.00

3.00

1.50

Inflation

2.00

2.50

2.00

2.50

2.50

0.50

Expected equity repricing

0.00

0.00

0.00

0.00

0.00

0.00

8.00

9.00

7.75

8.25

9.50

3.75

Total Real earnings growth

Total expected equity return Expected bond return Current 10-year government yield

4.25

4.50

4.25

4.75

5.50

1.50

Expected bond yield in 10 years

5.00

5.50

5.00

5.50

5.50

3.50

–0.25

–0.25

–0.25

–0.25

0.00

–0.75

4.00

4.25

4.00

4.50

5.50

0.75

4.00

4.75

3.75

3.75

4.00

3.00

Expected bond repricing Total Equity risk

premiuma

a

The equity risk premium is found by subtracting the total expected bond return from the total expected equity return.

©2004, AIMR®

www.aimrpubs.org • 35

Integrating Hedge Funds into a Private Wealth Strategy discussing this topic—what is the model portfolio, what is the strategic asset allocation, what is the investor’s starting point? Kneafsey’s view, and I agree, is to start with a “funding imperative,” or the investor’s reason for investing. A pension fund, for example, invests because it has liabilities it wants to extinguish. An endowment or foundation wants a series of cash flows in order to fund charitable giving or generate cash flow for a university or hospital. Individuals want to fund their retirement or specific bequests. Thus, the starting point is to find the basic reason the investor is investing. Take the average institutional investor, whom I will call Joe Average. For the purposes of illustration I will assume that Joe Average has an asset allocation (a.k.a. model portfolio) of 50 percent U.S. equity, 30 percent U.S. bonds, 17 percent international equity, and 3 percent international bonds. Using the numbers we generated previously, we know that he can expect a 6.84 percent return with that model portfolio. This situation is depicted in Figure 2. To meet his objectives, however, Joe Average needs a return of 10 percent a year. So, a gap exists between what the market will likely offer, the 6.84 percent, and what Joe Average wants, 10 percent.

Figure 2. Expected Return vs. Expected Risk for Joe Average Expected Return (%) Desired Return EAFE U.S. Equity

10.00 Return Gap Joe Average

6.84

Market Risk Premium 2.59% U.S. Bonds 4.25

Cash

Expected Inflation 2.00% Expected Real Return 2.25% Expected Risk

Strategy Tool Kit = Pursue Alpha = Lower Desired Return = Change Strategic Asset Allocation

Bridging the Gap Three strategies can be used to bridge the gap between what the market is offering and what Joe Average needs. The first strategy is to lower the return objectives (i.e., lower expectations). The sec36 • www.aimrpubs.org

ond strategy is to take on more market risk—in other words, move to higher expected return strategies by shifting the model portfolio and taking on more market risk. And the third is to pursue strategies that add exceptional return. I will focus on this third strategy, but to do so, I first need to explain the arithmetic of active management because it sets the scene for the challenge of active management. Active Management Arithmetic. Some wisdom from William Sharpe can help in understanding the challenge of active management. Sharpe calls this idea the “arithmetic of active management.”6 Suppose all assets (and I am talking about all assets— venture capital, private equity, commodities, anything imaginable) were put into one big pot. An investor (call him the passive investor) could buy a piece of that pot, or a little bit of everything, and get an average return. Similarly, the rest of the world (call them the active investors) would be buying and selling pieces of that pot. Sharpe’s analysis suggests that before costs, the return on the average actively managed dollar equals the return on the average passively managed dollar. In other words, the passive investor who goes out and buys a slice of everything will do as well as the average of all the (active) investors. If, in addition, the active investors pay higher management fees and incur high trading costs, then they will, as a group, do worse than their passive colleague. This insight is not based on highbrow mathematics. It is similar to the problem of logic in Garrison Keillor’s fictional town of Lake Wobegon, “where all the children are above average.” We know instinctively this cannot be so, but we somehow fail to apply the same principle to the investment world. Thus, an investor who merely buys everything (broadly defined) will do better than all the other investors who are trading pieces among themselves and paying high fees and incurring trading costs. The arithmetic of active management lays out the challenge for the active investor. To win at the active investment game, active investors must first jump the fee and trading cost hole they start in, and then they have to win in the zero-sum game that is played among all the active investors. The next section shows how we approach that task at BGI. Fundamental Law of Active Management. To measure our effectiveness as active managers, we use a simple measure called the information ratio (IR), which is the amount of active return (alpha) per unit 6

William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal (January/February 1991):7–9.

©2004, AIMR®

Closing the Gap between Expected and Possible Returns of active risk (tracking error). In other words, it is active return divided by active risk. An important relationship exists between the information ratio and alpha that is called the fundamental law of active management.7 It says the information ratio depends on two quantities. One is the skill level of the manager. We measure skill as the correlation between forecasted return and realized return.8 The second important variable is breadth, which indicates how frequently the manager gets to use that skill during the year: IR ≅ Skill ×

Breadth .

(4)

Think of yourself as owning a casino that has a roulette wheel. You can run the casino in two ways. The first way has low overhead: You have some high roller come in at the beginning of the year, put down $10 million on red or black, and spin the wheel once; regardless of the outcome, you close down for the rest of the year. The odds of the roulette wheel are certainly in your favor, but having one player come in and play a large sum of money is risky. The other way to run the casino is to have 10 million people come in and put down $1 each, and then each one spins the wheel. The expected return in each case is the same, but the risk of this second strategy is almost nil, and your advantage is spread over all those bets. This second approach illustrates the idea behind the fundamental law of active management. Managers should strive to spread their skill out as widely as possible by applying it to more securities and, if possible, by applying it more often. So, skill is a measure of the quality of the decision—the correlation between a manager’s return forecasts and the actual returns being forecasted. Breadth is the measure of opportunity available to the manager—the number of independent forecasts made each year. ■ Skill. How can managers increase their skill? The first way is to know more about the assets—that is, use complementary investment insights to forecast returns. Managers can look at the asset using the fundamental value approach or try to figure out its growth prospects. Additionally, they might want to determine how stable the earnings are. Or they might want to evaluate the asset across different economic environments. Further insight can be gained by examining the market forces on that asset: What are the market forces in its own industry; what is the market feeling about that asset right now? Many factors influence the return on the asset, and if managers aspire to know something about each one of 7 Richard

C. Grinold, “The Fundamental Law of Active Management,” Journal of Portfolio Management (Spring 1989):30–37. 8 Both forecasted and realized return are residual to any model portfolio return.

©2004, AIMR®

those factors, they can actually improve their skill— increase the signal. The second way to increase skill is to eliminate noise so that the manager can have focused information. When information arrives, it always contains little gems and a lot of junk. The manager’s goal is to filter out the junk and keep the gems. A refining process has to take place. Finally, the third way to increase skill is to implement that information efficiently through optimal portfolio construction. ■ Breadth. Increasing the breadth of a strategy is another way to increase the IR. One simple way to increase breadth is to look at more securities, but they cannot be just any securities. The manager must apply the same skill when evaluating the additional securities as when evaluating the original securities. If a manager is knowledgeable about U.S. stocks but not about European stocks, then adding European stocks to the portfolio mix will not increase the manager’s breadth because the manager does not have the same skill level in picking those stocks. Thus, the same skill has to be applied to the original and additional securities.9 Another way to increase breadth is to shorten the investment horizon. This approach, however, can be expensive because a shorter investment horizon increases portfolio turnover and thus increases costs. The final way to increase breadth is to free the manager from constraints. For example, allow the manager to use long–short instead of long-only strategies. A point to keep in mind is that both the owner of the funds and the investment manager can contribute to increasing breadth. To the extent that an investor gives funds to a manager and constrains the manager from exploiting an area where the manager has skill, the investor is limiting the chance of success. Investors, therefore, should look at benchmark-independent strategies, such as LIBOR plus 5 percent, and encourage managers to fully exploit their insights. Example of Increasing Breadth. This example shows two ways to use the exact same information. One way is somewhat constricted, and the other is much more open. The first approach describes a traditional tactical asset allocation (TAA) strategy. In the example, active positions must be ±5 percent relative to some strategic asset allocation mix, net short positions are not allowed, and active risk is targeted at 3 percent. 9

Of course, managers can help themselves with additional breadth and a lower skill level as long as their skill level will let them cover costs. For details, see Chapter 6 of Richard Grinold and Ronald Kahn, Active Portfolio Management: A Quantitative Approach for Providing Superior Returns and Controlling Risk, 2nd ed. (New York: McGraw-Hill, 2000).

www.aimrpubs.org • 37

Integrating Hedge Funds into a Private Wealth Strategy Assume that I am the manager and that Joe Average is my client. Remember that Joe Average’s asset allocation is 50 percent U.S. equity, 30 percent U.S. bonds, 17 percent international equity, and 3 percent international bonds. The effective strategic asset mix of Joe Average is shown in Figure 3. That allocation serves as the benchmark, and I must make my variations around it. Notice that most of Joe’s money is in U.S. stocks and bonds, with only a small portion in other asset categories. The range of decisions that I can make with the TAA overlay guidelines I just listed is given in Figure 4. I am allowed +5 percent on most asset classes, but I can have negative relative positions up to 5 percent only on U.S. bonds and stocks, although I can make small negative relative bets in the other positions. Of course, with regard to foreign assets, I have not been allowed to go long or short on currency, so I have to accept the currency risk when I take positions in, say, U.K. equities or Eurobonds; that is, I have to assume any associated exchange rate risk. As can be seen in Figure 4, I am not allowed any degree of freedom in currency. The second approach uses the same strategy but with a more efficient implementation. Once again, Figure 3. Effective Strategic Asset Mix of Joe Average U.S. Stocks U.S. Bonds Japan Stocks

Figure 4. Asset Allocation Ranges Available to a Traditional TAA Strategy Australia Canada France Germany Hong Kong Italy Stocks Japan Netherlands Spain Sweden Switzerland United Kingdom United States Australia Canada Euro Bonds Japan United Kingdom United States Australia Canada Euro Japanese New Zealand Norwegian Currency Swedish Swiss U.K. U.S. Singapore −5

U.K. Stocks

0

5

Allocation (%)

Euro Bonds Japan Bonds France Stocks Germany Stocks Switzerland Stocks Netherlands Stocks Canada Stocks Italy Stocks Spain Stocks Australia Stocks U.K. Bonds Sweden Stocks Hong Kong Stocks Canada Bonds Australia Bonds 0

38 • www.aimrpubs.org

10

20 30 40 50 Allocation (%)

60

my positions can be only ±5 percent and the targeted active risk is 3 percent. But now I am allowed to take net short positions. And this is a benchmarkindependent strategy. In other words, alpha and beta have been separated, so I can use certain strategies to manage the beta of the portfolio and other strategies to manage the alpha of the portfolio. I am also allowed to make separate currency decisions from the country decisions. To distinguish it from the TAA strategy, we refer to the overlay strategy as “global ascent.” The range of decisions I can now make is shown in Figure 5. The performance attribution for the traditional TAA and global ascent strategies along with a third strategy, which is sort of a way station between the two (it has relaxed the no-short constraint and is benchmark independent but the currencies are not separated), is shown in Figure 6. Note that the same ©2004, AIMR®

Closing the Gap between Expected and Possible Returns Figure 5. Asset Allocation Ranges Available to a Long–Short Strategy with Currency Separated Australia Canada France Germany Hong Kong Italy Stocks Japan Netherlands Spain Sweden Switzerland United Kingdom United States Australia Canada Euro Bonds Japan United Kingdom United States Australia Canada Euro Japanese New Zealand Norwegian Currency Swedish Swiss U.K. U.S. Singapore −5

Summary

0

5

Allocation (%)

forecasts are used in these three implementations. The skill is the same; the difference is in breadth. The dark gray area shows the returns if I had implemented the strategy using the initial constrained TAA. Although I would have made some money

©2004, AIMR®

from early 2000 until June 2001, by the end of the period, I would not have done very well (total return of roughly 1 percent). By letting up on the long– short constraint and being benchmark independent (the black area), I would have ended the period with a total return of approximately 11 percent. And finally, I gain additional breadth by allowing currencies to be separated from countries in the global ascent strategy; with this implementation, I would have a total return of close to 14 percent. So, using the exact same information, I added about 10 percent from the breadth of going short and another 3 percent by having the extra breadth of being able to invest in the currency. Thus, I increased the breadth quite a bit.

A gap exists between investors’ desires and what the market is offering. Market returns are not expected to be in the double digits. At BGI, we estimate a return of 8–9 percent for equity markets and 4–5 percent for bond markets. An investor looking for double-digit returns will thus have to “win” something that somebody else will have to “lose” because of the arithmetic of active management. That is, the investor will have to extract something out of the capital markets that somebody else is putting in and will have to jump over the fee and trading cost hurdle as well. As active managers, our job is to bridge the gap between what investors want and what the market is offering. We have to convince investors to lower their expectations, take on more market risk, and/or pursue alpha more aggressively. The trade-off for the amount of alpha we can get per unit of risk that we take is related to the skill and breadth of investment manager strategies. Successful investing requires both manager skill and breadth. If a manager has skill without breadth, that talent is largely wasted. Similarly, strategy breadth without manager skill is harmful to investors’ wealth.

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Integrating Hedge Funds into a Private Wealth Strategy Figure 6. Performance of Example Strategies, December 1998–June 2001 Cumulative Return (%) 16 14 12 10 8 6 4 2 0 −2 −4 12/98

6/99

12/99

Traditional TAA Overlay

6/00

12/00

6/01

12/01

No Short Constraint; Benchmark Independent (currencies not separated) Global Ascent Strategy

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©2004, AIMR®

Closing the Gap between Expected and Possible Returns

Question and Answer Session Richard C. Grinold Question: Do you have trouble shorting the securities you want? Grinold: Our firm is the largest lender of securities in the market, so we encourage people to go short because we like to lend securities. But there are some limitations on that, and some securities are difficult or very expensive to borrow. As our hedge fund efforts at BGI increase, we have noticed that if we want to short New Zealand equities, for example, there is not a big market for trading futures on New Zealand stock. We thus run into problems of moving around fairly large amounts of money in markets that are not as large as we would like. Question: What percentage of success is skill based versus breadth based? Grinold: The two are intimately tied together, and I don’t think you can separate them. Question: To what extent does trustee liability seem to constrain what boards are willing to do with respect to asset allocation? Grinold: A board, pension fund, or foundation should take a total fund approach. They should consider each piece in terms of its contribution to the whole fund. Unfortunately, they don’t do that. So, if some piece that is 2 percent of the fund blows up, they don’t want to answer questions about it. It is the same problem as having a portfolio manager who tries to get rid of all the stocks that made the headlines at the end of the quarter. Nobody wants to be the last holder of a WorldComtype issue. Unfortunately, that’s human nature, so personal risk aversion gets pushed into the port©2004, AIMR®

folio. I’m not sure what kind of institutional arrangement can be made to offset that problem. Question: How well do you think standard deviation measures risk, and is there both good and bad standard deviation? Grinold: I have never met a standard deviation I didn’t like. I tend to think of standard deviation as a measure of risk in anticipation. If someone goes rock climbing or hang gliding and comes back alive, was there no risk? I don’t believe so. That’s why I don’t go rock climbing—I know there is risk. I think of risk as risk in anticipation. If you have two ways to measure risk, then you basically stop measuring it because the multiple measurements are merely the prelude to a discussion in which anyone with an agenda can grasp the number that fits his or her case. Question: If you are trying to reach double-digit returns by using hedge funds, should you avoid absolute-return strategies? Grinold: No, I don’t believe so. I am trying to endorse absolutereturn strategies in this presentation. In other words, free yourself from traditional benchmarks and move to a nontraditional benchmark, which is something like LIBOR, because that’s the way you’re going to fund your portfolio. Question: Can you explain how you determined the excess corporate growth estimates in your table? Grinold: Excess corporate growth is another controversial number. The question is whether the corporate sector is going to grow faster or slower than the

country as a whole, as represented by GDP growth. There’s a couple of things you want to examine. You look at the real growth in GDP and the real growth in corporate earnings and try to determine whether the corporate sector is going to grow a little bit faster. So, you think about all the things in the noncorporate sector and all the things in the corporate sector. The noncorporate sector contains the government and a lot of lawyers and private offices—a lot of little fledgling firms that have not gotten into the capital markets yet. There’s a difference of opinion about this. If you talk to Rob Arnott and Peter Bernstein, they’d say that much of the real growth in the economy takes place over there with these fledgling firms.1 So, one can argue that corporations are going to grow a little bit slower. We think corporations are going to grow a little bit faster. At the end of the day it is not a big deal. As I said in the presentation, the real fuzzy number in the analysis is the guesstimate of the P/E at the end of the 10 years. Question: How do you manage client expectations given the uncertainties of the equity risk premium and the risks of pure alpha strategies? Grinold: We lay it out for them; we tell them how we arrived at our estimates. It is sometimes not fun to be the messenger, but as long as they know we’re operating in their best interests, it is not a problem. Question: How do you find the consensus expected returns for hedge funds? 1

Rob Arnott and Peter Bernstein, “What Risk Premium Is ‘Normal’?” Financial Analysts Journal (March/April 2002):64–85.

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Integrating Hedge Funds into a Private Wealth Strategy Grinold: The consensus expected return for hedge funds goes back to the arithmetic of active management. I would expect them to do about LIBOR minus costs. Some of the databases for hedge funds don’t exclude the ones that have gone out of business, so you just see the winners. When I go to invest my own money in hedge funds, I believe they are all guilty until proven innocent. That’s my starting spot. Question: Would you please address survivorship bias and persistence across public equity, absolute return, and private equity? Grinold: Survivorship bias is a problem. It is causing us to have trouble collecting the information that will give us an accurate estimate of what investment choices

42 • www.aimrpubs.org

were available in 1975 and how they would have done; any private equity firms that operated between 1975 and 1980 went out of business and thus tend to be excluded from the databases. But that has been a recognized problem for a long time. For the hedge fund industry, which is more of a newcomer, people will start to collect data and have a more accurate estimate of survivorship bias. Also, people want to know dollars invested and dollars that actually came out. So, when a firm like Long-Term Capital Management loses a billion dollars, it is a bigger deal than a firm making $10 million. Question: Are there other common statistical risk factors within hedge funds (e.g., Sortino down market capture) that express or

measure risk beyond standard deviation? Grinold: When looking in depth at a hedge fund, I certainly want to know about its use of derivatives, the degree to which it is levered, and the absolute number of dollars invested. When you have major events, correlations change radically and a lot of things become correlated. In other words, if all your strategies are in some way associated with liquidity or volatility and there is a market crisis, all your strategies will go south. Some changes increase the amount of risk radically over the past statistical risk, so you have to drill down and look at the exposure and try to find the commonalities and the degree to which you are exposed to liquidity events and other such events.

©2004, AIMR®

Hedge Fund Performance and Risk David A. Hsieh Professor of Finance Fuqua School of Business, Duke University Durham, North Carolina

Just as determining the return of individual stocks is difficult, determining the return of individual hedge funds is difficult. In aggregate, however, hedge funds tend to behave similarly (just as stocks do). By looking at asset-based style factors for hedge funds as a group (such as trend followers, merger arbitrage, fixed-income arbitrage, and equity long–short), the risk factors affecting their returns can be exposed and their behavior can be predicted for various market environments.

n my research, I have been exploring the risk factors in hedge funds—not the risk factors of a single hedge fund but the risk factors of hedge funds as a group. That is, I think about hedge funds as a portfolio. Just as individual stocks should not be thought of as one investment but should be thought of as a portfolio of stocks, hedge funds should not be thought of as one investment but should be thought of as a portfolio of strategies. And similarly, although the movements of individual stocks are hard to explain, the stocks in a portfolio tend to move together. The same is true for hedge funds, and that tendency is what my research is trying to uncover—common correlations or common risks across hedge funds. For example, fixed-income arbitrage managers tend to have similar strategies, but they do not have exactly the same strategies. A close look at these managers shows quite a dispersion of returns across the individual strategies. Some of that dispersion could be caused by a manager being misclassified, but mostly, it comes from the fact that managers do not share exactly the same set of traits. Individually, a manager may exhibit quite a bit of variation in return, but overall, managers tend to move up and down together. Therefore, my research agenda is to see whether I can extract common elements in hedge funds and determine the systematic risk factors that hedge funds are exposed to.

I

What Investors Need to Know Investors should view an alternative investment program in the same way they view a traditional invest-

©2004, AIMR®

ment program. They need to understand the risks, how returns are generated, and what the future holds. Investors are interested in hedge funds because they promise absolute returns. Everybody is looking for equitylike return but with bondlike risk. Hedge funds have low correlations with conventional asset classes, so they appear to have quite a bit of alpha that cannot be explained using a traditional risk– return measure. One problem with hedge funds is that their history is limited to roughly 10 years. How confidently can investors project into the future with only 10 years of history? And keep in mind that this recent 10-year period contained some unique events. The recent past has seen a big run-up in equity prices and then a decline, but most of the data come from the run-up period. Thus, the next 10 years could be quite different from the past 10 years. So, how can investors be confident that the hedge fund returns observed in the past 10 years will hold up in the next 10 years? Without an understanding of how hedge funds generate their returns, there is no way to estimate how they may perform in the next 10 years if the market environment changes. Another problem is the lack of transparency. Because investors do not really understand hedge fund strategies, they must rely heavily on data, which requires a lot of due diligence. Investors must understand what is going on with their portfolios; they must communicate with their managers to ensure that the managers are managing in a way that is consistent with their expectations.

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Integrating Hedge Funds into a Private Wealth Strategy An additional problem is the lack of a good benchmark. Equity investors can use a variety of benchmarks, such as the S&P 500 Index, the Russell 2000 Index, and various other small-cap and largecap indexes, and bond investors have the Lehman bond indexes. Equity and bond investors can thus compare the performance of the managers they hire against these benchmarks to see how well they are doing. No such external benchmarks exist for hedge funds. Typically, hedge fund benchmarks are created by averaging the past performance of other hedge funds. So, investors can compare a hedge fund manager against the average, but hedge fund investors have no external benchmark to use to determine whether these managers are doing well or poorly. William Fung and I are working on a model that will allow us to create external benchmarks for hedge funds. By looking at market prices, we are attempting to determine what a strategy ought to do. When we are done, we hope to have (1) benchmarks that will have a longer data history and (2) an explanation of how returns are generated. We want to develop rule-based benchmarks that can be created using market data. With such information, we can study the performance of these funds in past environments and in ones not yet observed. If someone wants to know how these funds would have performed in the 1970s, for example, we currently cannot answer that question because we do not have any hedge fund data going back to 1970. But the possibility exists of modeling hedge funds, which could provide a history of the various hedge fund risks. Such a model would allow for an examination of past exposures to different types of risk, thus letting us analyze what might have happened, say, in the 1970s. We would then have a way to understand various scenarios, including extreme events. In the end, constructing a portfolio means worrying about the tail events. We do not worry too much about the normal events because in normal times, most portfolios will be fine. It is only when the markets hit extreme bumps that portfolios run into trouble. We thus want to understand the impact of many different market events. There have not been enough of them in the past 10 years, so we have to look at a longer time period. Therefore, we are searching for rule-based transparent benchmarks that would allow us to look at what hedge funds would do and how they would fit into a portfolio. And if we can get alpha by selecting good managers, even better. But the first step is to make sure we can control the risk. If we know what the risks are, we can control them, which to me is the most important part of the portfolio. Capturing alpha is gravy; controlling risk is essential. 44 • www.aimrpubs.org

The standard model for looking at return, R, is the capital asset pricing model (CAPM): R = α + ∑βiFi + e,

where α is the average return that cannot be explained by any of the other risk factors, the risk factors for strategy i are Fi, βi represents the exposure for strategy i to that risk factor, and e is the return that is left over. In the traditional model, the F’s would be stocks and bonds. In Sharpe’s implementation of this type of model, he used mutual funds and successfully explained mutual fund returns by using traditional assets. Thus, if mutual funds are mainly buy and hold, they can easily be captured with these risk factors. In a 1997 article, we showed that the Sharpe model delivers poor results when applied to hedge funds; hedge funds are just not exposed to those types of risk factors.1 Some people say that most return comes in through the alpha for hedge funds. Others say that it is not just alpha; hedge fund returns also come from some other unknown risk factors. Our research, therefore, is an attempt to uncover the possible F’s, the risk factors, that could explain hedge fund returns. Figure 1 illustrates this process. On the horizontal axis are assets. The vertical axis shows different trading strategies used with the assets. Note that alternative strategies/markets are indicated by italics. Traditional managers, such as mutual funds, tend to buy and hold securities; therefore, the traditional benchmarks created for those managers assume a buyand-hold strategy. Take the S&P 500 Index, for example, which simply buys and holds the 500 stocks in that portfolio. Hedge fund managers do not do that. They buy some, short some, and typically trade in and out a lot. So, the S&P 500 is not a good way to understand hedge fund strategies. Hedge fund managers might use the exact same securities, but they would not trade them in the same way as traditional managers. So, we look at what hedge fund managers say they do and try to devise strategies that will mimic their behavior. It is like reverse engineering; we look at the returns and then ask how these returns could have been generated. How can a manager that trades individual stocks generate returns that do not look like those for a buy-and-hold strategy? Thus, we look at long–short, convergence trading, trend following, and so on—strategies that can be used with different assets from the ones used by traditional buy-andhold managers. 1

William Fung and David A. Hsieh, “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds,” Review of Financial Studies (Summer 1997):275–302.

©2004, AIMR®

Hedge Fund Performance and Risk Figure 1. Schematic of Hedge Fund Returns vs. Conventional Asset Class Returns Strategy Trend Following Convergence Trading

Alternative Investments

Strategies Asset Classes

Long−Short Buy and Hold (long only)

Traditional Investments Bond

Stock

Real Estate

Commodity

Spreads

Venture Capital

Location/Markets

Benchmark Construction The standard way to provide benchmarks for hedge funds is to create a peer-group average. The Hedge Fund Research (HFR) indexes, for example, divide funds into strategy groups—convertible arbitrage, fixed-income arbitrage, equity hedge, equity nonhedge, and so on. The HFR indexes have about 30 or 40 categories, although other hedge fund indexes use slightly different types of classification. Peer-group averages allow investors to compare managers only against other managers. Because they do not say a lot about what the risks are, we are trying to devise a better benchmark. Our approach uses return-based style factors, which groups managers with similar strategies together, such as equity long–short traders. We hypothesized that managers following similar strategies would have correlated returns. We then used a statistical method to extract the common components of their returns, or common risk factors. These common risk factors become the F’s in the CAPM.2 Then, we took an extra step: We linked that common correlation across this group of managers to something observable in market prices. We call that observable risk factor the asset-based style factor— asset based because we are going back to observable market prices to try to create something that will link to the returns of these common risk factors. Again, we are looking for common movements among hedge funds because, as with a diversified portfolio of stocks, those common movements are what investors need to worry about if they have a diversified portfolio of hedge funds. What the individual manager is doing is less important. 2 For

The problems with using individual hedge fund data (such as selection and survivorship bias) are well documented, so I will not spend much time on this topic. But I do want to show how different people can be observing different slices of the hedge fund market. I work with the Centre for Hedge Fund Research and Education at the London Business School, and it subscribes to three databases: the TASS database, the HFR database, and the MAR database, which has been sold to Zurich Capital Markets. Figure 2 shows that at the end of 2000, all three databases had about 1,000 hedge funds each, but they were not the same hedge funds. Only 315 hedge funds were common to all three databases, and about a third of the funds were in only one database. So, depending on whose data are being used, a rather different set of hedge funds could be observed. Interestingly, the average returns of the three databases tended to be highly correlated with one another, even though they were Figure 2. Hedge Fund Universe as of December 2000 according to HFR, TASS, and MAR

TASS: Total = 1,061 219 HFR: Total = 1,151 446

396 315

131

171 MAR Total = 909 292

further detail, see Fung and Hsieh 1997.

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Integrating Hedge Funds into a Private Wealth Strategy different hedge funds—further evidence that hedge funds do similar things and that a portfolio of hedge funds is exposed to similar risks.

Asset-Based Style Factors I previously mentioned our construction of assetbased style factors, which uses historical returns of hedge fund strategies to link common components to observed asset prices with a transparent, rule-based model that uses only investable assets.3 Four of these common hedge fund strategies are trend following, merger arbitrage, fixed-income arbitrage, and equity long–short. Trend Following. Trend followers attempt to capture large moves in markets, so they are directional players; they are either long or short. They wait until prices move in a particular direction and then jump on and follow the ride. They operate in the gold market, currencies, bonds—any liquid market with futures contracts. Although they do not like to trade stocks much, they use stock index futures a little bit. Basically, commodities, currencies, and bonds are where these trend followers trade. Academics have always had problems defining exactly what a trend is, especially ex ante. How does one devise a rule that captures a trend? Devising such a rule is difficult, but we know what the outcome ought to look like if the trend followers are right. For a big upward movement in price, the trend follower should be long and should be making money. Alternatively, for a big downward movement in price, the trend follower should be short and should be making money. In other words, the trend follower is a volatility player. The trend follower bets that markets will move a lot, in whichever direction. Trend followers do not claim to predict the move; they simply follow the trend. How can we generate returns that look like those of trend followers without knowing how they trade? We can use options. We can buy a call and a put. A call option allows the investor to buy an asset in the future at a predefined price, and if that underlying asset price rises, the investor makes the difference between the strike price and the final price. Similarly, a put option allows the investor to make the difference between the strike price and the final price if the asset falls in price. And if the investor buys both a call and a put, the investor is betting that this security will move. If it moves a lot, the investor will make money: If it goes up, the call will be worth money; if it goes down, the put will be worth money. 3

For more information, see William Fung and David A. Hsieh, “Asset-Based Style Factors for Hedge Funds,” Financial Analysts Journal (September/October 2002):16–27.

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We can thus capture the return characteristics of trend followers by using portfolios of straddles on the major markets. In a 2001 article, we found that trend followers are basically volatility players.4 Although the trend followers themselves do not claim to be replicating options, that is what their returns look like. In this article, we showed that the option portfolios that we generated explained about 50 percent of the return of the average trend follower. An R2 of 50 percent is not much if one is replicating returns of mutual funds because, typically, one could replicate those returns at an R2 of 90 percent, but the closest competitor that we came across could explain only 7 percent of the trend-follower returns. So, we were one order of magnitude better than this other explanation. We obtained interesting results using postsample analysis. Our initial study used data up through 1997. We took the average return for trend followers and ran a regression on the option portfolios to get the beta coefficients (i.e., the exposures). We held those data fixed and then ran the portfolio forward in time to see how closely or poorly the replication strategy worked. The dotted line in Figure 3 is the replicating portfolio of straddles—five portfolios of different types of straddles estimated using data that started in 1997. The solid line is the average actual return of the trend followers. The match is not perfect, but it is a reasonably good fit for estimating trend-follower strategies. These trend followers are thus very interesting. They tend to make money when markets are volatile. And markets tend to be most volatile when the S&P 500 falls rapidly. So, notice in Figure 3 the large positive returns from this strategy in August 1998 and also on a few occasions in the past couple of years. The returns of trend followers are U-shaped, meaning that in big down markets and big up markets, they make unusually high returns, but in normal markets, they do poorly. This example illustrates one way to use market data to try to indicate how different types of managers might perform in different market environments. To protect a portfolio on the downside, I would use some of these trend followers if the portfolio contained a lot of stocks and bonds. Trend followers do, however, have very high volatility. Their standard deviations are roughly 25 percent, but that variation stems from their betting on volatilities. Their returns move around, but that volatility is in some sense good volatility. 4 William Fung and David A. Hsieh, “The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers,” Review of Financial Studies (Summer 2001):313–341.

©2004, AIMR®

Hedge Fund Performance and Risk Figure 3. Trend Followers: Long Straddles (Volatility), January 1998– December 2002 Return (%) 15 Actual

10

Predicted

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Merger Arbitrage. Mark Mitchell and Todd Pulvino published an article in 2001 in which they tried to replicate the returns of merger-arbitrage funds.5 They took all announced mergers and did what the merger arbitrageurs would do: Buy the target and short the acquirer. Their returns, plotted against S&P 500 returns, are shown in Figure 4. Most of the time, their returns were not correlated with those of the S&P 500; they ranged between zero and about 3 percent, irrespective of S&P 500 performance. But for extreme negative returns of the S&P 500, their returns were also negative. Why? Because mergers get called off in a bad market. Mergers typically com5

Mark Mitchell and Todd Pulvino, “Characteristics of Risk and Return in Risk Arbitrage,” Journal of Finance (December 2001):2135–75.

7/00

1/01

7/01

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plete, except when the S&P 500 falls. The merger arbitrageurs are betting that mergers will complete; that is where they get their returns. They are basically selling insurance policies against the failure of a merger. So, if mergers fail, they lose money. If mergers complete, they pick up the insurance premium. Their returns look like a put option on the S&P 500. Fixed-Income Arbitrage. Many fixed-income hedge fund strategies are exposed to credit spreads, where the credit spread is defined as the difference between Moody’s Baa corporate bonds and the U.S. 10-year T-bond. So, not surprisingly, this strategy will not show up in a lot of standard risk factors because of the spread bet. These managers are betting that two interest rates will move around. Using

Figure 4. Merger-Arbitrage vs. S&P 500 Returns, 1990–2002 Merger-Arbitrage Monthly Return (%) 4 2 0 −2 −4 −6 −8 −20

−15

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0

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S&P 500 Monthly Return (%)

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www.aimrpubs.org • 47

Integrating Hedge Funds into a Private Wealth Strategy historical data to try to understand these funds is a problem. Figure 5 shows the history of the credit spread going back to the 1920s. The spread has been as high as 7 percent, which means Baa corporate bond yields were 7 percent higher than the 10-year T-bond yield. Even in the 1970s, the spread was as wide as 4 percent. But the data we observe on fixedincome hedge funds are from the 1990s, as shown by the circled area of the graph. Fixed-income hedge funds do well when spreads narrow or stay the same. So, the 1990s were particularly beneficial to these funds because the spread was narrow. Roughly in late 1998, however, a spike appeared. This spike corresponds to the LongTerm Capital Management (LTCM) debacle and the Russian default. LTCM was highly exposed to this risk factor, the spread. LTCM used its risk management system of 10 years’ worth of history, thinking that was a lot of history. But their 10 years’ worth of history did not contain many big increases in credit spreads. When LTCM did see a big spread, the firm collapsed. Other fixed-income hedge funds lost money, but not as much as LTCM; its leverage was much more than that of the other funds. To understand how a fund would perform in different market environments, investors need to know the market risk factors they are exposed to. Armed with this information, they can see how fixedincome hedge funds would have performed, for example, in the 1970s. Thus, investors are not seeking

to predict whether a disaster will happen but, rather, what it would do to their portfolios if it did happen. Equity Long–Short. Equity long–short hedge funds have exposure to the S&P 500, but they also have exposure to the spread factor between large-cap and small-cap stocks. These fund managers are stock pickers. They typically buy stocks that have fallen in price, especially in the small-cap stock area. To hedge their position, they short large-cap stocks that are easy to short and whose price movements are fairly predictable. So, not surprisingly, the spread between large-cap and small-cap stocks is a risk factor in equity long–short. Summary. We took the risk factors for the four styles discussed and used them to explain a typical fund-of-funds portfolio. In so doing, we achieved respectable R2s close to 70 percent. Figure 6 shows how well we were able to track the average returns of the HFR fund-of-funds index (solid line). The dotted line is the fitted values using the risk factors. Thus, the fitted line tracks the ups and downs pretty well. Therefore, these four asset-based style factors do a respectable job in capturing the key risks in a welldiversified portfolio of hedge funds. We will probably add more risk factors to them as we study other styles, but with these four factors, we can at least help investment managers and funds of funds identify the kinds of risks that may be present in their portfolios.

Figure 5. Credit Spread History, 1924–1999 Spread (%) 8 7 6 5 4 Data Sample

3 2 1 0 12/24

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12/33

12/42

12/51

12/60

12/69

12/78

12/87

12/96

©2004, AIMR®

Hedge Fund Performance and Risk Figure 6. Actual and Fitted HFR Fund-of-Funds Index, January 1998– December 2002 Return (%) 8 Actual

6 Fitted

4 2 0 −2 −4 −6 −8 −10 1/98

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7/98

1/99

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Integrating Hedge Funds into a Private Wealth Strategy

Question and Answer Session David A. Hsieh Question: Some people say that hedge fund data will not be reliable until the industry is fully regulated. What do you think? Hsieh: Managers ought to disclose their return history. If the level of regulation entailed simply filing a report with the SEC that says what the history is and what returns are, that’s pretty innocuous. That level of regulation would be beneficial. It would be good for the industry because people could study hedge funds and be confident that the data they use

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are providing results that are representative of the industry. I don’t think anyone is advocating that hedge funds be regulated in the same way that mutual funds are regulated. Question: Please expand on the question of whether there is a hedge fund bubble. Hsieh: The growth in assets in hedge funds has been phenomenal, so from a historical perspective, it appears to be a bubble. But I can’t really tell at this moment.

The question is: How will these funds perform going forward? Assuming we have a reasonable equity market and credit spreads don’t go crazy and so forth, a reasonable target for hedge fund returns is 6–8 percent at the welldiversified level, such as funds of funds. That number is lower than the historical number, but the environment has changed. So, if the numbers come in around that amount, there is no bubble. But if we see hedge fund returns much lower than that, then I think it is a good sign that there is a bubble.

©2004, AIMR®

The Nuances of Manager Selection Alexander M. Ineichen, CFA1 Managing Director and Head of Derivatives Research UBS Warburg London

Although hedge funds can potentially enhance portfolio performance, they come with risks. Thus, selecting a hedge fund manager should not be taken lightly. As part of the selection process, investors must understand the various types of hedge funds, choose the right approach for their needs and skill level (direct investment or use of a fund-offunds manager), develop an appropriate asset allocation strategy, and finally, identify and continuously monitor the top managers.

earning how to identify and choose the best hedge fund managers is an essential part of making hedge funds a beneficial component of any investment portfolio. To provide the guidance that investors need, I will examine four aspects of manager selection: • Understanding the trade-offs among different types of hedge funds. • Selecting the right approach for the investor— direct investment versus the use of a fund-offunds manager. • Combining hedge funds and developing an appropriate asset allocation strategy. • Identifying and choosing the best hedge fund managers.

L

Trade-Offs among Hedge Fund Types I believe the greatest difference between the traditional asset management industry and hedge funds is how hedge funds define risk and, as a result, manage risk. In fact, I would say that risk management can derive from one of two environments: (1) the relativereturn environment, in which long-only, buy-and1 Mr. Ineichen is now managing director and global head of AIS research at UBS Investment Research in Zurich.

Note: The views and opinions expressed in this article are those of the author and are not necessarily those of UBS. UBS accepts no liability over the content of the article. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.

©2004, AIMR®

hold strategies are used to beat a benchmark, or (2) the absolute-return environment, in which the goal is to achieve absolute positive returns. Relative Return versus Absolute Return. The difference between relative-return and absolutereturn environments has much to do with the way risk is defined. In a benchmark, long-only environment, risk is defined as tracking risk (or active risk), which means that the risk-neutral position is the benchmark and a deviation away from the benchmark leads to an increase in risk. For example, for an equity manager who is 100 percent invested in the market benchmark to move 5 percent of the portfolio into cash would actually mean increasing risk because the ex ante tracking error to the benchmark would increase. The mandate of the relative-return manager, therefore, is to capture asset class premiums (typically in equities and bonds) and pass the return distribution of the benchmark to the end investor. Such behavior is close enough to a normal distribution that I feel confident referring to it as a symmetrical return profile. Absolute-return managers, such as hedge fund managers, do not define risk relative to a benchmark. They use a measure that I refer to as total risk. Hedge fund managers are driven by profit and loss and seek a return distribution that is, ideally, skewed to the right-hand side. They want to exploit investment opportunity on one hand and preserve capital on the other hand. From the profit and loss statement, they essentially want a lot of “P” and as little “L” as possible. Unlike relative-return managers, hedge fund managers want to establish an asymmetrical return profile. www.aimrpubs.org • 51

Integrating Hedge Funds into a Private Wealth Strategy One way to compare these two different risk management paradigms is demonstrated in the following figures. Figure 1 presents the annualized returns for the HFRI Fund of Funds Composite Index and MSCI World Index, which I am using as a proxy for a long-only equity portfolio. Assuming that the reference point is zero (or the risk-free rate), the magnitude of the positive returns for both indexes (that is, the upside volatility) is similar. Both indexes demonstrate high return volatility on the upside. In contrast, however, the downside of their return distribution is quite different. The hedge fund index shows a low return volatility on the downside that is not seen in the MSCI World Index. This low volatility occurs on the downside because hedge fund managers have a mandate to reduce risk relative to a benchmarked long-only equity portfolio and, therefore, have the flexibility to respond to changing market conditions—flexibility that managers with a market benchmark do not have. Figure 2 is what I call an “underwater perspective,” a slightly unorthodox way to visualize drawdowns. It provides an underwater perspective because, like swimmers, once investors take a dive, they have an incentive to return to the surface, that is, recover from losses. Figure 2 shows (from 1990 to August 2003) the HFRI Fund of Funds Composite Index and the S&P 500 Index as percentages of their previous all-time peaks. So, if the index hovers around the 100 percent line, it is essentially moving from one all-time high to the next. This figure illustrates the difference between defining risk in absolute

terms and defining it according to a benchmark. Hedge funds, which operate in absolute-return space, have, by and large, moved from all-time high to alltime high, but the S&P 500, an index often used to benchmark long-only investment mandates, has had much more erratic returns on the downside. Figure 3, which depicts another underwater perspective, compares the HFRI Fund of Funds Composite with the S&P 500, Nasdaq, and Nikkei 225. The upward-sloping lines show the potential time of recovery for those indexes that were underwater as of July 2003 if an annual growth rate of 8 percent is used. Assuming that investors are loss averse and prefer to avoid large drops in returns that require years to recover from, the strong interest in hedge funds is understandable. One could argue, therefore, that the elevated interest in hedge funds derives not necessarily from hedge funds making money for their investors in good times but from their not losing it during market turmoil. Comparison of Hedge Fund Styles. Ma n y investors regard hedge funds as a separate asset class comparable, for example, to private equity or real estate. But my view is that hedge funds are simply another form of active management, and their styles are simply alternatives to the traditional buy-andhold, long-only strategy.2 2 For more on hedge fund classification, see Richard Bookstaber, “Hedge Fund Existential,” Financial Analysts Journal (September/ October 2003):19–23.

Figure 1. Annual Total Return for the MSCI World Index and HFRI Fund of Funds Composite Index, January 1990–July 2003 Annual Total Return (%) 30 20 10 0 −10 −20 −30 90

91

92

93

94

MSCI World

95

96

97

98

99

00

01

02

03

HFRI Fund of Funds Composite Index

Notes: Data based on U.S. dollar total returns. For this period, MSCI World returned 5.5 percent a year; the HFRI Fund of Funds Composite returned 10.3 percent a year. Source: UBS (Datastream, Bloomberg).

52 • www.aimrpubs.org

©2004, AIMR®

The Nuances of Manager Selection Figure 2. HFRI Fund of Funds Composite Index and S&P 500 Index as Percentages of Their Previous Peaks, January 1990–August 2003 Percent 100 95

HFRI Fund of Funds Composite Index

90 S&P 500 Index

85 80 75 70 65 60 55 50 90

91

92

93

94

95

96

97

98

99

00

01

02

03

Note: Data based on U.S. dollar total returns. Source: UBS (Datastream, Bloomberg).

Figure 3. Indexes as Percentages of All-Time Highs with Loss Recovery at 8 Percent a Year, 2000–2025 Percent 100

HFRI Fund of Funds Composite

90

Nasdaq

80 70 Nikkei 225

S&P 500

60 50 40 30 20 10 0 00

05

10

15

20

25

Note: Data based on local currency total returns, January 1990–July 2003. Source: UBS (Datastream, Bloomberg).

When considering hedge fund styles, I tend to group funds according to (1) manager activity, (2) the effect of the style on the investor’s portfolio, and (3) the source of the returns generated by the fund. Hedge fund manager activity can be categorized as relative-value strategies, event-driven strategies, ©2004, AIMR®

and opportunistic strategies. Relative-value activity includes funds specializing in convertible arbitrage, fixed-income arbitrage, and equity market-neutral tactics, such as statistical arbitrage or fundamental arbitrage. Event-driven activity includes risk arbitrage, investing in distressed securities, and capitalwww.aimrpubs.org • 53

Integrating Hedge Funds into a Private Wealth Strategy restructuring arbitrage. Opportunistic activity includes macro funds; short-selling funds; long region, sector, or style funds; emerging market funds; and long–short equity funds. Generally speaking, market exposure tends to be low for relative-value managers, high for opportunistic managers, and somewhere in between for event-driven managers. Another way to look at the hedge fund universe is according to the investor portfolio effect, which is based on a working paper by Thomas Schneeweis and Richard Spurgin.3 According to Schneeweis and Spurgin, the low-volatility strategies, such as relative-value strategies, are primarily intended to reduce the risk of a traditional portfolio, whereas event-driven strategies and equity hedge strategies are primarily designed to enhance returns. Finally, global asset allocation strategies are designed to be portfolio diversifiers, with discretionary and systematic asset allocation strategies being total diversifiers and short selling, which is a unique strategy with nearly constant negative correlation with equities, being a pure diversifier. The third method of categorizing hedge fund styles—by source of return—is intuitive. For example, in event-driven strategies or relative-value strategies, the purpose is to capture a risk premium. Because markets are fairly efficient, capturing these premiums is difficult, which is why some investors refer to the return also as a “complexity premium.” In risk arbitrage, for example, the manager tries to assess the fair premium in an announced merger (the premium reflecting the probability of the merger falling through) and looks for discrepancies between this assessment of fair value and market prices. This task can be complex, hence the term complexity premium. In contrast, equity-hedged (a.k.a. long–short equity) strategies typically gather their returns through superior information-based company-specific research. Such a bottom-up, research-driven process is designed to gather returns as a result of a better understanding of the prospects of companies. Finally, trading-oriented hedge funds rely on technical as well as fundamental analysis, irrational market behavior by central bankers and other market participants, and supply/demand imbalances to forecast directional market movements, trends, forced buying or selling, or other market phenomena.

Direct versus Fund-of-Funds Investments To begin the discussion of the best hedge fund approach for an investor to choose—whether direct 3

Thomas Schneeweis and Richard Spurgin, “Hedge Funds: Portfolio Risk Diversifiers, Return Enhancers or Both?” Working paper, Center for International Securities and Derivatives Markets, 2000.

54 • www.aimrpubs.org

investment or a fund of funds—consider a few observations of passive and active strategies in hedge fund management. Passive strategies seem most applicable to traditional forms of investment, such as cash instruments, government bonds, and large-cap stocks. Such instruments are readily used under conditions of efficiency, and active management is not likely to add value. But as investments take on more of the characteristics of alternative instruments, such as high-yield bonds and convertibles, market inefficiencies grow and the potential for unlocking the value in those inefficiencies increases so that active management strategies are more likely to make a positive difference in an investor’s portfolio. Thus, when an investor is considering whether to choose a fund-of-funds manager or go directly to individual hedge fund managers, the question the investor must ask is whether hedge fund market information is readily available. Can the investor use a Bloomberg terminal or the Internet to download all the relevant data, or is more expert information needed? If the investor can assimilate the required information at no or low cost, then the investor may be comfortable taking the direct investment approach, but if the investor needs additional expert information or the information can be obtained only at high cost, then using a fund-of-funds manager can make sense. Manager Selection and Strategy Selection. When I am asked which is more important, manager selection or strategy selection, I can only respond that they are both important. The historical data show that from year to year, a wide dispersion exists between the annual returns of the worst strategy and the best strategy. A dispersion also exists between the best and the worst managers, but the dispersion becomes significant only as the strategies move from traditional to alternative investment management. For those managers who deal with traditional fixedincome or traditional equity investments, the dispersion between the best and the worst managers is small, but so is the likelihood of large relative returns. But among managers who use absolute-return strategies and private capital strategies, the dispersion can become large. For someone with an edge and access to higher quality information, these strategies offer tremendous opportunities, both to the manager and the investor. For those without an edge, the wide dispersion is, potentially, a minefield. To further illustrate the difference between the best and the worst managers, depending on strategy, consider the private equity data gathered by David ©2004, AIMR®

The Nuances of Manager Selection Swensen shown in Table 1.4 The dispersion of returns between the first and third quartiles of venture capital managers is 16.5 percentage points (pps). For leveraged buyout funds, the dispersion is 22.7 pps. Not only does such dispersion inhibit the investor’s ability to budget for systematic risk, but also earning the median return on these two strategies is not enough to counterbalance the possibility of large losses. In comparison, the dispersion of returns in the traditional U.S. equity strategy is minuscule. Based on these data, Swensen argues that unless the investor can be confident that the manager has enough of an edge to be in the first or second quartile, the investor is better off avoiding private equity strategies all together.

Table 1. Dispersion of Returns in Private Equity Manager Ranking

Venture Capital

Leveraged Buyouts

Maximum

498.2%

243.9%

Quartile 1

U.S. Equity 18.1%

17.1

23.8

Median

8.1

13.2

15.5

Quartile 3

0.6

1.1

14.9

Minimum

–89.7

–65.9

13.2

lst–3rd Quartile Range

16.5 pps

22.7 pps

16.6

1.7 pps

Source: Swensen (2000).

I not only concur with Swensen’s opinion but also would argue that the hedge fund industry is reaching a point where the only investors who should be in absolute returns are those with access to top-quartile managers. Anything less and investors will not be compensated for their risk. Fortunately, mature fund-of-funds organizations have the industry knowledge to choose top-quartile managers and pass that value on to their clients. Unfortunately, such investors (both in the United Kingdom and, to some extent, in the United States) have been extremely sensitive to fees, which means they are averse to paying a second layer of fees to a fund-offunds manager. Thus, they are trying to develop the internal staffing and resources needed to invest directly with hedge fund managers. Typically, however, the staffing they create is too limited in number and has far too little experience. Furthermore, their access to information is too often restricted to commercially available databases, from which they are unlikely to gather the information necessary for selecting the best hedge fund managers. 4

David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (New York: Free Press, 2000).

©2004, AIMR®

In comparison, a mature fund-of-funds organization might have 15–20 analysts with an average of eight years of experience in the hedge fund industry. The differences in quality are too great to ignore and could, I am afraid, lead to negative headlines about pension funds not doing the proper due diligence, and all because they wanted to avoid a second layer of fees. An allocator, such as a fund-of-funds manager, typically has an edge because of its broad understanding of the hedge fund universe, which currently includes approximately 9,000 managers, not all of whom are listed in commercially available databases. My suspicion is that the best ones are not listed, although perhaps the worst ones are not listed either, which leaves the direct investor to choose among the mean. And I have already demonstrated that for certain hedge fund strategies, choosing a manager that reaches merely the mean is not good enough. Selection Process. The process of selecting a manager and allocating assets is essentially the same whether the investor is a fund-of-funds manager or a direct investor in hedge funds. It is an iterative process, and once it has begun, it has no definite ending point; after the initial process of choosing managers and constructing a portfolio are completed, both the managers and the portfolio go through a continuous process of evaluation. In this subsequent evaluation, the performance of managers is reviewed, and managers are either retained or replaced; the portfolio undergoes risk management assessment and is restructured as conditions warrant. This process continues as long as the portfolio is maintained. As for the steps in initial manager selection, they follow a funneling process. The fund-of-funds manager (or the direct investor) begins by screening the entire universe of fund managers and, using certain accepted criteria, identifying 200–500 managers that are then ranked according to preference. After choosing among these managers for the top 50–100, the manager or investor conducts due diligence to select the 10–50 managers that will constitute the hedge fund portfolio. During the course of the past few years, the vocabulary of hedge fund management and the strategies involved have become familiar to financial industry professionals. The concept is no longer mysterious, and investors are becoming more adept at allocating assets among various strategies. But I strongly believe that when it comes to manager selection and monitoring (especially firing), a fund-offunds organization adds critical value. Certainly, it adds value on the strategy level, but in terms of costs, its position on the learning curve, and its available www.aimrpubs.org • 55

Integrating Hedge Funds into a Private Wealth Strategy resources, a fund-of-funds manager has a distinct advantage over most (but not all) direct investors. Hedge Funds and Historical Evidence. In the asset management industry, historical performance is the factor that makes or breaks a firm’s ability to market itself successfully because the assumption is that historical performance foretells future performance. But does the evidence support this assumption? In regard to mutual funds, this issue is the subject of ongoing debate, but no evidence—neither return data, the Sharpe ratio, nor alpha testing— supports the assertion that past performance is an indicator of future performance. In fact, empirical research suggests the opposite—that mutual fund performance tends to revert to the mean. The same appears to be true for hedge funds and fund-of-funds organizations, as shown in Figure 4. According to data available from Credit Suisse First Boston and Standard & Poor’s, of the 112 funds of funds in the top quartile in 1999, only 27 remained in the top quartile in 2000; 16 dropped to the second quartile; 18, to the third quartile; and 51, to the bottom quartile. A similar pattern followed for the next few years until only 1 of the original 112 remained in the top quartile in 2003. Two studies that I often quote offer contradictory opinions on persistence. Franklin Edwards and Mustafa Caglayan argue that performance persists among the upper-quartile hedge funds, and Vikas Agarwal and Narayan Naik argue the opposite.5 Both articles do agree, however, on the lower quar5

See Franklin R. Edwards and Mustafa Onur Caglayan, “Hedge Fund Performance and Manager Skill,” Journal of Futures Markets (November 2001):1003–28; Vikas Agarwal and Narayan Y. Naik, “Multi-Period Performance Persistence Analysis of Hedge Funds,” Journal of Financial and Quantitative Analysis (March 2000):327–342.

tiles of hedge fund managers. Losers, they say, have a tendency to remain losers. So, it appears that performance persists among the lower quartiles but not necessarily among the higher quartiles. Personally, I am skeptical about hedge fund research related to alpha. Quantifying alpha, by definition, requires a benchmark, and hedge funds do not have a classical benchmark. One of the beauties of a relative-return approach is the possibility of quantifying some sort of information ratio. But no one has yet developed a generally accepted metric for hedge funds. Until such a development occurs, I think any alpha data regarding hedge funds should be treated with caution.

Hedge Funds and Asset Mix Asset managers generally agree that increasing the number of stocks in a portfolio reduces the portfolio’s volatility—to a point. For individual S&P 500 stocks, volatilities are typically 25–30 percent, but by combining stocks, a manager can lower that volatility to about 18 percent—at which point the incremental benefit flattens out and adding more stocks has little effect on portfolio volatility, as shown conceptually in Figure 5. The same concept seems to apply to hedge fund investments. Using the services of only one or two managers leaves an investor’s hedge fund portfolio with a fair degree of nonsystematic risk. By increasing the mix of hedge fund managers, that volatility can be lowered substantially to about 6 percent and, in some instances, even lower. Some disagreement surrounds the optimal number of hedge fund managers to have in a portfolio. Some would say that running the historical data through a mean–variance optimizer results in a line that flattens out at 12–15 managers, so 12–15 should

Figure 4. Performance Persistence of Funds of Funds, 1999–March 2003 Year

1999

2000

2001

Jan 2002− Mar 2003

Quartile 1

112

27

3

1

Quartile 2

16

3

0

Quartile 3

18

13

0

Quartile 4

51

8

2

Source: Credit Suisse First Boston and Standard & Poor’s.

56 • www.aimrpubs.org

©2004, AIMR®

The Nuances of Manager Selection Figure 5. Optimal Number of Constituents in a Portfolio Volatility (%) 30 25 20 15

Stocks

10 5

Hedge Funds

0 1

5

10

15

20

25

30

35

40

Number of Constituents

be the investor’s target. My view is that an optimizer is not a practical tool because it does not consider the risk of a maximum drawdown. For example, assume an investor uses 12 hedge funds equally weighted in a portfolio. Then assume that one of those funds goes bankrupt. The investor is faced with an 8.3 percent drawdown. Thus, I recommend including 20 or more managers in a hedge fund portfolio. If an investor holds, say, 25 hedge funds equally weighted and one goes bankrupt, the maximum drawdown will be “only” 4 percent.

Correlation between Strategies. Correlation— especially the volatility of correlation—is one of the relevant factors in portfolio construction, and correlations among hedge fund strategies are quite low, thereby providing certain diversification benefits. Furthermore, the volatility of correlation (i.e., the rate at which correlation changes) among strategies is also low, especially when compared with the volatility of correlation among different sectors in the stock market. But historical data on correlation are unreliable because large events have an extreme impact on any portfolio. For example, if credit spreads explode or liquidity dries up, the correlation matrix can change dramatically, if only for a short period. Therefore, it is extremely important to understand what is driving the risk factors behind a strategy because what really matters is the ex ante correlation, not the historical correlation coefficient, which can be extremely misleading, as shown in Figure 6. In this figure, I have charted the rolling 24-month correlation of an equity market-neutral index and the S&P 500. In addition, I have charted the rolling 24-month return of the S&P 500. My intention is to demonstrate that relying on some sort of correlation matrix is not necessarily a good idea. For example, during the bull market, the correlation of the market-neutral index and the S&P 500 reached 0.8. This result is intuitive because the name of the game in a market-neutral strategy is to have a positive return in every month. So, this strategy

Figure 6. Rolling 24-Month Correlation Coefficient and Return, 1997– August 2003 Rolling 24-Month Correlation Coefficient

Rolling 24-Month Return (%)

1.0

100

0.8

80

0.6

60

S&P 500 Return

40

0.4 Correlation of Equity Market-Neutral Index vs. S&P 500

0.2

20

0

0

−0.2

−20

−0.4

−40

−0.6

−60 97

98

99

00

01

02

03

Note: Based on monthly returns of HFRI indexes from January 1990 to August 2003. Source: UBS (Datastream, Bloomberg).

©2004, AIMR®

www.aimrpubs.org • 57

Integrating Hedge Funds into a Private Wealth Strategy is not tied to the rhythm of the S&P 500, and yet the two indexes at one point showed a historical correlation of 0.8. This high correlation results because the market-neutral strategy strives to produce positive returns in both up and down equity markets, so when equity market returns are primarily positive (as in an equity bull market), the correlation between the two indexes is positive, and when equity market returns are largely negative (as in a bear market), the correlation becomes negative—going to –0.5. Correlation between Managers. As with historical correlations between strategies, historical correlations between managers should also be regarded with caution. And just as the investor needs to understand the drivers of the strategies more than the correlations, the investor also needs to base decisions on what exactly the different managers do. For example, the universe of managers can be perceived as existing along a continuum of diversity. At one extreme are those, such as risk-arbitrage managers, that operate within a fairly homogeneous market (for example, U.S. mergers and acquisitions) and show a high degree of correlation. At the other extreme, however, are those, such as macro managers, who operate in a heterogeneous market (because the manager’s mandate is flexible). The correlation between macro managers is very low, which means that managers working in heterogeneous strategies add more incremental value in terms of reducing portfolio volatility than those working in homogeneous strategies. Another way of considering the correlation between hedge fund managers is to contrast them with traditional asset managers. The traditional longonly manager has a fairly constant beta, whereas hedge fund beta is dynamic. It changes over time, as reflected in the low transparency that investors perceive in hedge funds. For example, when using a benchmarked manager, the investor knows today what the positions will be one week from today: The positions will be close to the benchmark. By contrast, an investor using a hedge fund manager might know the positions today (if the investor has see-through transparency), but the investor will not know what the positions will be one week from today because the hedge fund manager has the authority to change the positions according to shifting market conditions and, therefore, can alter the beta of the portfolio. The same is true for other risk factors, such as exposure to spreads or credit risks. As for operational risk, a hedge fund is comparable to a venture capital investment; the risk is much higher than that represented by, for example, a $50 billion asset manager that is regulated and might even have a credit rating. Another important factor for the investor is being able to distinguish between systematic and nonsystematic risk; the investor needs to be compen58 • www.aimrpubs.org

sated for taking on exposure to systematic risk, whereas nonsystematic risk can be managed through diversification. Just as investors should hold many stocks of different types, so should they engage a variety of hedge fund managers. Variability in Hedge Fund Construction. When historical returns, historical volatilities, and historical correlation coefficients of various hedge fund strategies are optimized and charted, as shown in Figure 7, the results show different configurations for hedge fund portfolios. The vertical axis shows the mean–variance optimal weight for each strategy in the portfolio; the horizontal axis shows the volatility. My purpose is to demonstrate that different risk preferences among investors (or fund-of-funds managers) will lead to different hedge fund portfolios. For example, an investor who has a low tolerance for losses will have a bias toward the lower-volatility strategies, such as market neutral or convertible arbitrage. An investor with a higher tolerance for volatility will have a bias toward more directional strategies.

Finding the Best Hedge Fund Managers Hedge funds, assuming they survive, resemble other types of products. They go through a maturity cycle— from start-up to rising star to blue chip—and understanding this cycle can be of great benefit to anyone trying to choose the best hedge fund managers. Using the Maturity Cycle. Funds that are just entering the market are like start-ups. They do not have a track record (that ever-important history of past performance), and potential investors are wary of hiring seemingly untested fund managers. The supply of such funds is typically much larger than demand, and these funds must struggle to market themselves to investors. But if a fund survives for three, four, or five years and proves to be successful in the business, it becomes first a rising star and then, subsequently, a blue-chip firm. Such investment managers are few and far between, and the demand for them is high. They can pick and choose among the many investors who seek their services. The time that is most ripe for manager selection, then, is the middle part of the cycle, a period that is referred to as the “allocation window”—when hedge fund managers have proven they can survive but have not yet become so successful or rare that they are all but impossible to hire. These managers are the rising stars that investors should be seeking, but investors need accurate information and sufficient resources to do effective research because manager selection is a research-driven process. ©2004, AIMR®

The Nuances of Manager Selection Figure 7. Mean–Variance-Efficient Portfolios for Different Volatility Levels Optimal Weight (%) 100 90 80 70 60 50 40 30 20 10 0 Minimal Risk

3

4

5

6

7

8

9

Portfolio Volatility

Equity Market Neutral Risk Arbitrage

Convertible Arbitrage Distressed Securities

Maximum Risk

Fixed-Income Arbitrage

Macro

Equity Hedge

Note: Based on monthly U.S. dollar returns of HFRI indexes from January 1990 to May 2001. Source: UBS (Bloomberg).

In a crowded market, reliable information is essential if one is to find the rising stars, which is why fund-of-funds managers are in a stronger position to make good selections than are direct investors who are just entering the market. Fund-of-funds managers generally have been involved in the market long enough to have developed an accurate sense of the market as well as the ability to discern true quality from the market’s perception of quality. But keep in mind that the market’s perception of quality is not always correct. If a manager has a long track record, high transparency, high liquidity, and asset growth, then the consensus view is likely to be accurate. But such managers are likely to be the blue chips and thus less available for hire. Therefore, the best opportunities to unlock quality are provided by a bottom-up research-driven process that can uncover the managers who apply lesser-known, or misunderstood, strategies and create underappreciated differentiation. Maturity, Return, and Attrition. When discussing equities, analysts and investors often refer to the small-cap effect, in which smaller stocks outperform larger stocks. With reference to hedge funds, the size of a fund is less important than its maturity. In fact, evidence is now suggesting that younger hedge ©2004, AIMR®

funds offer higher returns than mature funds, perhaps because younger funds are less diversified and more nimble. The downside, however, is that younger funds normally carry higher operational (i.e., nonsystematic) risk than mature funds: Their dispersion of returns is higher, their business risk is higher, and their attrition rate is higher. The attrition rate among hedge funds is an important issue, and the rate is increasing, as shown in Table 2. According to data collected by Gaurav Amin and Harry Kat, annual attrition among hedge funds, in general, increased from 2.20 percent in

Table 2. Attrition among Hedge Funds, 1994–2000 Year

Beginning (#)

New (#)

Dead (#)

End (#)

Attrition (%)

1994

455

151

10

596

2.20

1995

596

197

15

778

2.52

1996

778

229

48

959

6.17

1997

959

330

47

1,242

4.90

1998

1,242

83

113

1,212

9.10

1999

1,212

172

140

1,244

11.55

2000

1,244

104

153

1,195

12.30

Source: Amin and Kat (2003).

www.aimrpubs.org • 59

Integrating Hedge Funds into a Private Wealth Strategy 1994 to 12.30 percent in 2000.6 The reason for this development is not that these hedge funds have gone bankrupt or suffered a 100 percent negative return. Rather, they are undergoing the effects of a deleveraging that is occurring in the hedge fund industry. As the industry matures, less risk is being taken, and with less risk come lower returns, which means a decline in performance-related fees. If a young hedge fund has only its management fee and is not earning its performance-related fee, it will not survive for long. If such attrition continues, the value offered by fund-of-funds managers is likely to grow.

6

Gaurav S. Amin and Harry M. Kat, “Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias over the Period 1994– 2001,” Journal of Alternative Investments (Summer 2003):57–73.

60 • www.aimrpubs.org

Conclusion Several observations seem applicable to the hedge fund industry. First, hedge funds are diverse and offer many different styles that can be used to serve different purposes. Second, picking funds without an edge is adventurous, to say the least, and I do not recommend it. Third, at this stage of the maturity cycle, some fund-of-funds managers have an ewdge in terms of experience and, therefore, can provide added value in selecting, monitoring, and, most important, terminating hedge fund managers. Fourth, diversity among different hedge fund strategies allows investors to create relatively low-risk portfolios with high-risk constituents. Fifth, finding and hiring hedge fund managers is difficult and expensive, but monitoring them and knowing when to fire them are potentially more important.

©2004, AIMR®

The Nuances of Manager Selection

Question and Answer Session Alexander M. Ineichen, CFA Question: Do you think a fundof-funds manager can become too large to continue adding strong returns? Ineichen: I don’t think the capacity constraint for fund-of-funds managers is as extreme as it is for some of the single-strategy hedge funds. I think a fund-of-funds business model is more scalable than that of a senior hedge fund. The most recent past, however, saw a rise in the number of large singlestrategy hedge funds migrating to

©2004, AIMR®

become multistrategy managers. Some of these multistrategy investment managers are now competing with funds of funds. In addition, there is the rise of hybrid business models. I expect these trends to continue as the industry matures. Question: How can I get access to funds that are not in commercial databases?

recently, the hedge fund industry had a cottage-industry appeal to it. A lot of information was exchanged by word of mouth. A fund-of-funds manager, I believe, would argue that this is still the case today. The answer to your question is simple: You need to build the database yourself or, alternatively, hook up with a consultant or fund-of-funds provider.

Ineichen: If you are not in the information loop, you are at a competitive disadvantage. Until

www.aimrpubs.org • 61

Hedge Fund Due Diligence and Legal Considerations Joseph H. Nesler Partner Gardner Carton & Douglas LLP Chicago

Although the U.S. SEC is considering requiring that hedge fund managers register with the SEC just as managers of mutual funds must register, investors should be aware that registration alone does not provide them with adequate safeguards. The only way for investors in hedge funds to be reasonably secure in their investment is to conduct basic due diligence. Certain qualifications for investing in hedge funds have also been designed to protect investors.

he U.S. SEC has been investigating the possibility of regulating hedge fund managers. As a matter of fact, the SEC staff has put forth a proposal that certain hedge fund managers be required to register as investment advisors under the Investment Advisers Act of 1940 (Advisers Act). Although the SEC is considering setting a threshold that requires hedge fund managers to register only if managed assets exceed a certain dollar amount (e.g., $10 million or $25 million), the general thrust of the SEC’s proposal is to require the registration of hedge fund managers, who in many cases are currently exempt from registration. But even if the SEC proposal goes through, I would counsel investors interested in hedge funds not to view registration with the SEC as a substitute or surrogate for conducting their own due diligence. Indeed, registration of a manager with the SEC is a pro forma process. It involves the manager filling out a form and filing it with the SEC. Admittedly, the form does contain important information supplied by the manager, but one can never be sure that the manager is telling the truth, and the SEC does not necessarily verify what the manager is saying. Yes, the SEC does review the completed form, but if the manager indicates he uses a long-only strategy but the examiner sees that the manager is engaging in some short activities as well, the examiner ordinarily will simply tell the manager to indicate the use of

T

Editor’s note: The joint Question and Answer Session of Joseph Nesler and Michael Serota follows Michael Serota’s presentation.

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short selling the next time the manager fills out the form. Thus, it is a perfunctory review and not a substitute for thorough due diligence. The SEC has touted investment registration as being a great benefit to the investing public, but I must confess that I am skeptical of regulation. I cannot see how a second- or third-year examiner at the SEC can march into a firm like Long-Term Capital Management and explain to the principals why its risk management mechanisms are not appropriate. The fact of the matter is the SEC staff examiners who conduct examinations of registered advisors are not equipped to determine whether an advisor is capable of preserving investor capital. It is just not something they can do. Therefore, never assume that SEC registration proves anything. Consequently, hedge fund investors have to keep in mind that they must examine the manager themselves. In general, investors can get some helpful information from looking at a manager’s Form ADV, which is filed with the SEC, but they have to do their own due diligence, especially for hedge funds. And the due diligence has to be qualitative as well as quantitative in nature. The cold, hard truth is that a document is only a piece of paper. A hedge fund manager can make all sorts of promises in the governing documents of a hedge fund, but if the hedge fund manager is not trustworthy, he can simply disregard everything that was said in those documents, which is how most fraud occurs. Of course, in so doing the manager opens himself up to a lawsuit, but ©2004, AIMR®

Hedge Fund Due Diligence and Legal Considerations the possibility of a lawsuit or an SEC enforcement action does not always stop managers from committing fraud, as we well know. Thus, a key aspect from an investor’s standpoint of looking at a manager is focusing on not only the quantitative aspects but also the qualitative aspects: actually meeting the manager before investing with him, sizing up the manager, person to person; looking at the manager’s offices; and simply assessing the reliability of the manager. Conducting qualitative due diligence is no guarantee that everything will work out, but all things being equal, it is better than not engaging in that process. Therefore, in this presentation, I will cover the basic due diligence steps (quantitative and qualitative) that investors should take when investigating hedge funds and discuss the investor requirements for investing in hedge funds.

Basic Due Diligence Conducting due diligence before investing with any manager is important, but because of the recent high-profile cases of hedge funds “blowing up,” due diligence has taken on added importance when the manager is a hedge fund manager. Therefore, at a minimum, investors need to pursue basic due diligence. Alignment of Interests. The single most important issue from an investor’s standpoint is whether the fund manager is investing his own money in the fund because having the manager invest alongside of the investors helps to ensure that their interests are aligned. A problem can arise if the manager invests too much of his own money because the manager may become fearful of taking risk, but as a basic matter, investors should make sure that the manager is investing his own money and that the amount is substantial in relation to the manager’s net worth. Even if the manager has money invested, investors should check to see whether the manager has the right to withdraw his investment at any time. A look at the hedge fund’s partnership agreement or the limited liability company agreement will show whether the manager can withdraw his money, all or part of it, at any time or whether his fortunes are tied to those of his investors. If a manager says he has X amount of his own money in the fund but takes it out 10 days later, investors have not received much protection in the form of tying the manager’s interests with their interests. Investment Mandate. Investors should review the hedge fund limited partnership agreement or limited liability agreement to see whether the manager’s investment mandate is broad or narrow. Some investors may be looking for a manager who focuses ©2004, AIMR®

on a particular style, and the manager may intend to focus on that style. But if the hedge fund documents provide the manager with wide discretion to invest in any manner that the manager sees fit, style drift can result. Investors who are looking for a manager with a specific focus should thus ask for some confirmation from the manager, either in the form of a side letter or some other document, that the manager will not materially change his investment strategy without first informing investors of that shift and allowing them to exit the fund before that shift is implemented. Hedge fund documents should also be reviewed to uncover any restrictions imposed on the manager when implementing his investment strategies, such as requirements for diversification and leverage. In many cases, the documents list specific restrictions. For example, they might restrict manager leverage in excess of 2:1 or require the fund to be diversified in at least 10 different issues at any given time. In other cases, the documents simply contain guidelines. Therefore, investors seeking a manager who will adhere to specific restrictions need to make sure that the underlying documents are phrased in terms of hard-and-fast restrictions, not guidelines that the manager intends to follow but can alter at will. Transparency. Endless debate has centered on manager transparency and its worth to investors. I take a neutral position on the issue, but if transparency is important to the investor, the question to ask is: Do the fund documents provide the information that the investor needs to assess the risk of investing in the fund? If the manager is not willing to provide that information, then either bite the bullet and invest in the fund anyway or find a comparable fund, if possible, that will provide the required information. Two transparency-related questions are: What types of reports are submitted to investors, and how frequently are they submitted? Other questions are: What accounting principles, such as U.S. GAAP, apply to those reports, and are any exceptions made to these principles? Michael Serota is right on target when he says investors should deal only with fund managers who have the fund’s financial statements audited annually.1 Having an annual audit is such a standard feature for hedge funds that investors who invest in a fund that does not provide for an annual audit should have their heads examined. Fee Structure. A fund’s fee structure, regarding management fees and incentive fees, is another hot topic. The key question to ask is: Is the fund’s fee structure competitive with the market? Admittedly, 1 See

Michael Serota’s presentation in this proceedings.

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Integrating Hedge Funds into a Private Wealth Strategy defining what the market is is hard, and of course, the market changes. A further complication in defining the market is that different types of funds have different fee structures. A fund-of-fund’s fee structure is somewhat different from that of a single-strategy fund. So, one way for an investor to determine whether a fund’s fee structure is at the market is to canvass various funds that use the same strategy. In this way, the investor can determine whether these other funds’ fee structures are similar to or depart radically from that of the fund the investor wants to invest in. If the fee structure is higher than that of these other funds, a fair question to ask the manager is: Why is your fee structure so high compared with your peers’? Another important aspect of hedge fund investing, and one that the SEC has touched on, is the valuation of fund assets. This issue is important for many reasons. For investors, the key concern is whether they are being given a proper valuation of their equity stakes in the hedge fund. But the issue of valuation is also important for determining the amount of fees that the manager gets because management and incentive fees are usually based on the value of the fund’s assets. Thus, if the manager has the ability to value the fund’s assets for the purpose of determining fees, the manager has a conflict of interest or an incentive to place the highest possible valuation on those assets. Therefore, investors need to review closely which valuation principles are being applied when the manager values the fund’s assets. Although, ideally, investors want these valuation principles to be fairly tight, they will always give the manager some leeway because certain financial instruments do not have a ready market and thus finding a public price for them is impossible. As a general matter, investors want to make sure that the valuation principles make sense in light of the type of fund they are investing in. Expenses. Another important item that affects the economics of the investment is which expenses the manager may recover from the fund. Funds vary greatly in terms of the types of expenses paid to the manager. In many cases, the idea is that the manager receives a management fee for reimbursement of all the regular costs and expenses incurred in running the fund. The incentive fee, in such a case, is then the manager’s compensation for running the fund. Some funds, however, not only pay the manager a management fee but also pay certain expenses. The validity of this practice could be debated endlessly, but the real question when deciding whether the expense arrangements are fair is: What is the fund’s net performance over a long period of time? Regardless of the answer, however, investors should try to deter64 • www.aimrpubs.org

mine the various expenses that the manager will bear out of his own pocket and the expenses that the fund will bear because, in the long run, those expenses will affect investment performance. One item that is usually not paid by the hedge fund but is covered by the manager himself is overhead expenses. Then again, some funds pay a portion of the manager’s overhead expenses. In those cases, a fair question for the investor to ask is: What is the management fee designed to cover if it does not cover overhead? Investors should also ask whether the fund has a cap on organizational and offering expenses. Again, practice varies widely. Some funds provide for a cap, usually for marketing purposes. Young funds, startup funds that want to attract new investors may want to make sure investors are not scared off by the potential negative effects of high fees. Thus, in these funds, the manager may agree to pick up expenses in excess of a certain level. Such caps, however, are not used in more mature funds. Another area that relates to expenses is whether the manager is permitted to engage in soft-dollar transactions. Generally, in a soft-dollar transaction, the manager directs the fund’s commission business to particular brokers in exchange for certain goods and services. In some cases, the goods and services that the broker provides benefit the fund itself. In other cases, however, those goods and services benefit the manager either exclusively or substantially and may not benefit the fund at all, which is inconsistent with the AIMR Soft Dollar Standards.2 In such cases, investors should ask the manager why he, as opposed to the fund, should be entitled to receive benefits from the use of the fund’s brokerage commissions. In many cases, funds are marketed through broker/dealers or other financial intermediaries. The question from the investor’s perspective is whether placement fees are paid to these intermediaries and if so, who bears them. Sometimes the manager will bear them out of his own resources; namely, he might take part of his management fee or part of his incentive compensation to pay a broker for soliciting a particular investor. The general market practice is not to have the fund itself bear placement fees. They are usually borne either by the new investor in the fund, who knows up front that he or she will bear a fee that must be paid to the broker, or by the manager out of his own resources. Agreements with Affiliates. A provision that an investor would want to examine in a limited partnership agreement or limited liability company agreement governing a hedge fund is whether the fund can enter into agreements or otherwise transact 2

See the Standards of Practice Handbook (Charlottesville, VA: AIMR, 1999):181.

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Hedge Fund Due Diligence and Legal Considerations business with affiliates of the manager. Of course, this is a conflict of interest question because if the manager can conduct such business, the transaction can potentially benefit the manager at the expense of fund investors by overpaying the affiliates for services. Usually, managers agree that if they are authorized to retain affiliates, they will do so only on a basis that approximates an arm’s-length transaction. Redemption/Withdrawals. Fund liquidity is one of the key aspects of investing in a hedge fund. That is, what are the investor’s redemption or withdrawal rights? Although the fund documents may say that the fund provides quarterly or monthly redemptions, the fine print usually says that the general partner retains the authority to suspend redemptions and redemption payments in certain circumstances. Thus, investors are not typically given an absolute right to redeem on, say, a quarterly, monthly, or semiannual basis because the manager retains the right to suspend redemptions and redemption payments under certain circumstances. The point is that investors must look at those “certain” circumstances and see if they can live with them. The bottom line is that an investor cannot invest in a hedge fund with the notion that she will be able to get out, say, quarterly because, in certain cases, she might not be able to get out. Indeed, in many cases when she can get out, the manager will provide her with only a portion of the amount (such as 90 percent) to which she is entitled and will then withhold the remainder until a reasonable period thereafter so that the fund manager can determine whether the value at which she was let out was the correct valuation at the time. Negotiation of Terms. In many cases, the terms of investment are negotiable. But in some cases, the manager will simply say that he will not negotiate with the investor because the investor is not bringing enough money to the table. Whether fees are, in fact, negotiable depends on the bargaining strengths of the parties at the table. Obviously, start-up managers who are trying to attract money are more likely to bargain because they want to get investors into the fund so they can start managing money. More mature managers, all other things being equal, are less likely to bargain on terms, but it never hurts to try. An investor should always ask the manager whether any investors were admitted on more favorable terms. The manager may say “yes” or “no,” or the manager may be willing to bargain with the investor. But negotiating is something that an investor should definitely pay attention to. Conflicts of Interest. Every offering document will contain a conflict-of-interest section that outlines ©2004, AIMR®

all the various conflicts of interest to which a manager is subject in connection with managing a particular fund. The question is whether these are boilerplate descriptions or whether they raise red flags. The answer may not be intuitive to someone who does not frequently read these documents. Therefore, investors should discuss these disclosures with their counsel or somehow try to figure out a way to determine what is boilerplate and what is not. In many cases, managers are not afraid to disclose these conflicts, but there may be, in fact, a huge potential conflict in which the manager can favor his own interests at the expense of the fund and its investors. If that conflict is disclosed in the documents and investors do not object, they cannot later complain that the manager engaged in those practices potentially to the detriment of the fund or the investors. Standard of Care. Another aspect that is frequently contentious in the context of investing in a hedge fund is the standard of care that applies to the manager in managing the fund. Will he be liable if he is negligent, or does he have to behave somewhat more badly than simply negligently, such as grossly negligently? My view is that it does not matter in the long run. In the first place, some courts do not even recognize any distinction between negligence and gross negligence. If they see the words “gross negligence,” they will simply disregard the word “gross” and say that the manager is held to a negligence standard. Second, most sophisticated hedge fund investors understand that if they sue a manager simply for making a mistake that affects performance, as opposed to engaging in an outright fraud, the hedge fund industry is a small enough place that that investor will find it very difficult to invest in any other hedge fund. My advice to investors is not to worry about whether the standard is negligence or gross negligence. I do not think it matters. What matters is whether the investor has done her due diligence on the manager and is comfortable that he will not engage in fraudulent activity. Removal of General Partner. Another provision that investors argue over frequently is the right to remove or replace the general partner. The general partner will resist having such a provision, and the general partner’s response to the investor is usually, “If you do not like it, walk with your feet. You have redemption rights. That is your remedy in the case that you do not like the way I am managing the fund.” That argument is appealing because what is the investor going to replace the manager with? He will be replaced with another manager, so why not exit the fund and invest in a fund managed by another manager? This removal provision, although argued over a great deal, is meaningless in the long run. www.aimrpubs.org • 65

Integrating Hedge Funds into a Private Wealth Strategy In-Kind Distributions. Many funds state that they have the ability to make in-kind distributions. From the investor’s standpoint, the important question is whether the manager can give one investor an in-kind distribution and another investor cash so that the first investor is left holding a potentially illiquid investment and the other, cash. Most sophisticated investors will make sure that if the manager has the right to make in-kind distributions, they have to be made pro rata to investors who are redeeming at a particular time; one investor cannot be favored, or disfavored, in terms of the type of asset that is distributed in connection with the withdrawal or distribution. Clawbacks. As a general matter, a limited partner or a member who invests in a limited liability vehicle cannot lose more than the amount that she has invested; if she invests $10 million, she cannot lose more than $10 million. But it is also the case that limited liability company agreements and limited partnership agreements provide that they can claw back certain distributions that they have made to the limited partners. So, suppose you invested $10 million in a fund and you got $15 million back. If the manager determines that you were cashed out at an improper value or if a creditor of the partnership is knocking at the partnership’s door, you may be asked to give back some of that $15 million. Therefore, investors need to pay attention to the situations in which they may think they have gotten money back but that money is not necessarily firmly in their hands if the partnership has the right to claw back certain amounts from them. Amending the Partnership Agreement. Often, limited liability company or limited partnership agreements give the manager the authority to unilaterally amend the partnership agreement. In such cases, they also usually provide certain protections for the investors, such as no amendment can reduce the amount of distributions to which a limited partner or member would otherwise be entitled and no change can result in the limited partner or the member having general liability. If the manager is given this right to unilaterally amend the partnership agreement, investors need to make sure that they have at least some baseline protection. Dispute Resolution. Buried at the end of every limited partnership agreement or limited liability company agreement is a dispute resolution clause. Sometimes it is as simple as specifying the state, such as Delaware, whose laws will govern any disputes. But sometimes it goes further and says, for example, not only that the dispute shall be governed by Dela66 • www.aimrpubs.org

ware law but also that it shall be settled exclusively in the court of the State of New York, that it shall be done by arbitration, and that a jury trial will be waived. None of these stipulations are necessarily bad. In fact, they can benefit both the manager and the investor because it is hard to know up front for any given case who will reap the benefit of these provisions. So, in a sense, they are somewhat neutral. The point is that investors should know before investing in the hedge fund what their rights will be in the event of a dispute between them and the manager.

Investor Qualifications When investing in a hedge fund, investors must potentially pass four qualification tests. These tests arise under different federal securities and commodities laws and are designed to serve different purposes. I will not go into them in great detail, but the four tests are designed to determine whether the investor is an accredited investor, a qualified client, a qualified eligible person, or a qualified purchaser. Accredited Investor. The baseline test is the accredited investor test, but in certain cases, the fund may require that investors satisfy the other three tests as well. To be an accredited investor, the individual must have either $200,000 in annual income for the past two calendar years and a reasonable expectation of the same in the current year ($300,000 with spouse) or $1 million in net worth. Something that frequently creates a problem is trusts. In many cases, trusts do not qualify as accredited investors unless they have a minimum of $5 million in assets. The problem that arises frequently is that someone establishes a trust for the benefit of, say, her child and the trust does not have $5 million in assets but the trustee of the trust is an accredited investor, the person who contributed assets to the trust is an accredited investor, or sometimes even the child in his or her own right is an accredited investor because of assets outside the trust. Nevertheless, unless that trust has $5 million in assets, it will not be considered an accredited investor, and in many cases, a fund simply will not take the investment. Qualified Client. The test for a being a qualified client is having net worth of $1.5 million or the investment being at least $750,000. Qualified Eligible Person. The qualified eligible person test states that the investment portfolio must have (1) a market value of at least $2 million, (2) at least $200,000 in exchange-specified initial margin and option premiums for commodity ©2004, AIMR®

Hedge Fund Due Diligence and Legal Considerations interest transactions on deposit with a futures commission merchant, or (3) a portfolio containing a proportionate combination of the assets described in the preceding two requirements (e.g., $1 million in securities and other investments together with $100,000 in exchange-specified initial margin and option premiums). Qualified Purchaser. To be a qualified purchaser, individuals must own certain types of investment assets whose value (net of indebtedness incurred to acquire such assets) is not less than $5 million. “Family companies” must meet three criteria. They must • be owned, directly or indirectly, exclusively by or for two or more natural persons who are related as siblings or spouses (including former spouses); direct lineal descendants by birth or adoption; spouses of such persons; the estates of such persons; or foundations, charitable organizations, or trusts established by or for the benefit of such persons; • not be formed for the specific purpose of investing in the fund; and

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own certain types of investment assets whose value (net of indebtedness incurred to acquire such assets) is not less than $5 million. “Family trusts” also must meet three criteria: • Present and future beneficiaries, vested or contingent, must consist exclusively of two or more individuals who are related as siblings or spouses (including former spouses); direct lineal descendents by birth or adoption; spouses of such persons; the estates of such persons; or foundations, charitable organizations, or trusts established by or for the benefit of such persons. • The trust must not be formed for the specific purpose of investing in the fund. • The trust must own certain types of investment assets whose value (net of indebtedness incurred to acquire such assets) is not less than $5 million. For other types of trusts, the trust must not have been formed for the specific purpose of investing in the fund, investment decisions must be made by a “qualified purchaser,” and each settlor (i.e., each person who has contributed assets to the trust) has to have been a “qualified purchaser” at any time such settlor made a contribution of assets to the trust.

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Integrating Hedge Funds into a Private Wealth Strategy

Question and Answer Session Joseph H. Nesler Michael J. Serota Question: Starting in 2004, should investors refuse to lend their shares in order to get the 15 percent tax rate on dividends?

Question: Does the $5 million test hurdle for hedge funds apply to revocable trusts or irrevocable trusts or both?

Question: Because hedge funds are audited only annually, how do you gauge accuracy on a monthly mark-to-market basis?

Serota: It all depends on what the net economics are. The question is whether your marginal revenue from the securities lending is greater than what you would get from holding the security long and getting the 15 percent dividend tax rate. It is purely an economic analysis.

Nesler: Ordinarily, if the trust is a so-called grantor trust or a revocable trust—in other words, a trust that the grantor can terminate at any time—you don’t need to look at whether the trust itself has $5 million in assets. The real question is whether the grantor himself is an accredited investor. The grantor could be an accredited investor if he has $1 million in net worth or if he has had gross annual income in the past two years of at least $200,000 (or $300,000 with his spouse) and reasonably expects to hit that $200,000 level (or $300,000 with his spouse) in the current year. So, in the case of a grantor trust, you basically disregard the trust itself and look through to the grantor, and if the grantor is an accredited investor, then the trust will automatically be an accredited investor. For an irrevocable trust, however, the $5 million test does apply.

Serota: What you want to look for is a third-party administrator, record keeper, or prime broker. Having a third party involved is not a guarantee that the purported performance is accurate, but if you are receiving information from a third-party prime broker or custodian, for example, you know there is at least some verification. You could also ask to have the information audited semiannually or quarterly.

Question: Should an investor be concerned if a fund’s fee structure is too low relative to other funds? Nesler: I have run into some managers who believe that fee structures are too high, and even though they could charge what the market bears, they don’t. So, in some cases, you might be faced with a manager who, as a matter of principle, believes that he is charging a fair fee and does not think that he needs to charge more. In other cases, the low fee could result from someone who has had a hard time attracting money. If it is a small fund, a good question to ask is why the fee structure is lower than normal. As I mentioned earlier, investors can ask why a fee structure is higher than others, so it is fair to ask why a fee structure is lower. Question: Is an out-of-themoney call option on a stock considered hedged for the 15 percent tax consideration? Serota: No. If your option is out of the money, you probably have not substantially reduced your risk of holding that long position. So, your holding period on the long position should continue, and you should be OK. 72 • www.aimrpubs.org

Question: When using hedge funds in a private placement life insurance structure, are you now required to invest only in insurance-dedicated funds? Serota: If the product is private, you should not run afoul. What they’re trying to do is put you in the Section 1260 regime, which says that you are treated as the owner of the underlying hedge fund itself and the insurance product is really not there. Generally, if the product is not offered to anyone other than you, then you should be OK under the rulings. If it is offered to a larger audience, then you run afoul of those provisions.

Nesler: The only difficulty is that many onshore funds do not have third-party administrators. The general partner simply administers the fund itself rather than hiring a third-party administrator to do so. But it is becoming more common now for onshore funds to hire administrators because it gives investors a degree of comfort. So, in some cases, you simply won’t have that administrator, but if the fund has a prime broker, that’s just as good because it will also value the assets. Serota: There’s been some noise by at least one accounting firm about not providing audit services for funds that don’t have a thirdparty intermediary. As we move forward, given the environment that we’re in, the accounting firms, at least the larger ones, are going to require some type of third-party custodian or administrator between the fund and the accountants, just to add another level of verification. ©2004, AIMR®

Legal and Tax Considerations Question: Has the IRS issued opinion letters on structured products? Serota: There are opinion letters on different types of structured products. If you’re trying to develop a product that will provide you with deferral and/or conversion, you can still do that under the right circumstances. You should work with your accountants and attorneys to structure the product. Thus, it can still be done, but under very tight constraints. Would you ask for a ruling from the IRS in such a situation? Generally, no. You run the risk of the IRS turning down the ruling request. So, in a situation in which you put together a structured product, you will want to get an opinion from counsel. With this opinion, at least you get to the point at which you can take the position and feel somewhat comfortable that the product will work. But generally, you won’t request a ruling. Nesler: In addition, by asking for a ruling, not only do you risk the possibility of getting an answer you don’t want to hear but you also have a timing consideration. Getting a ruling is not done quickly. It sometimes takes years. Question: What are the various levels of opinion available on products structured as warrants, options, and so on, in hedge funds that move all the returns to the end date as capital gains rather than ordinary income? Serota: The question relates to a structured product and using a derivative as an intermediary investment for direct investment in a fund in order to generate a capital gain on the back when the product is ultimately sold. So, for example, you would buy a European-style option that could be exercised only at the back end; you would exercise it at that point and have a capital gain on the disposition. ©2004, AIMR®

You are generally going to get a “more likely than not” opinion from counsel. It depends on your level of risk tolerance as an investor. I am much more aggressive, personally, when it comes to dealing with an advisor and his or her own money than I might be in dealing with the fund itself. The fund is your livelihood, and you have more risk if something goes wrong with a structured product in the fund because those are your investors that you are affecting. When you are creating the product at the advisor level, it is for you or your partners and the advisor. So, as far as I’m concerned, if you want to be aggressive, be aggressive. But you don’t want to do something without an opinion. Certainly, you want to make sure you have a “more likely than not” opinion, and a properly structured product will at least get you a “more likely than not” opinion. Nesler: Of course, no opinion, even a clean opinion, is a guarantee. As long as the attorney who rendered the opinion has done so in a manner that’s not negligent, then even if the opinion is wrong, the attorney can’t be sued. And that’s even more the case in a “more likely than not” opinion. All the attorney is saying is that in her view as an experienced practitioner in the tax area, more likely than not this should be the result. But the IRS may take a different position. And that IRS decision will not affect the validity of that attorney’s opinion in the sense that it will not afford an investor the right to sue the attorney simply because the IRS took a contrary position. The virtue of getting the opinion is that the likelihood of being assessed any penalties or getting thrown into jail is very small if the IRS does take a different position. That’s the real protection. Getting the opinion doesn’t necessarily mean you’re going to get capital gains treatment, but it will prevent you from getting penalized.

Serota: And it also protects you in the sense that you know you have purchased a product that is at least plausible. Some people are plugging products with dubious economics, and the opinion will at least tell you that there’s some validity to what’s happening and it is not outside the realm of possibility. Question: Can you invest in a hedge fund via your IRA? Serota: Yes, but if you invest in a domestic fund that’s treated as a partnership for federal tax purposes, which most domestic hedge funds are, and if that partnership leverages through borrowing, you potentially get UBTI for the IRA. In other words, the IRA will get taxable income from that fund. It will have to file a tax return and so on. For that reason, most taxexempt investors don’t want to go anywhere near a domestic hedge fund that uses leverage. They prefer to invest in the offshore sister company or offshore feeder fund that feeds into a common master with the onshore fund in order to avoid the UBTI problem. Nesler: The only caveat to that answer is that you have to consider the cost of paying the UBTI for investing in the U.S. feeder versus investing in a foreign feeder and potentially losing any withholding that takes place on U.S. source dividend income. Even though you’ve paid a UBTI tax, investing in the U.S. feeder may very well cost less on an after-tax basis than investing in a foreign feeder that may have a significant withholding. So, you have to ask how much UBTI there is, how much has been there historically, how much leverage you use, and what your withholding is if you invest in a foreign feeder. Serota: You should also ask what your transaction expenses will be for filing a tax return and having your accountant figure this out. That’s another consideration. www.aimrpubs.org • 73

Integrating Hedge Funds into a Private Wealth Strategy The bottom line is there is no legal prohibition against investing in a hedge fund via an IRA. The question is whether you want (or would be allowed) to do it under the circumstances. Question: Would you explain further what a PFIC is? Serota: Suppose I wanted to defer taxation on some money indefinitely. I could put the money into an offshore corporation, which would not be a flowthrough entity for tax purposes, and get stock in the corporation. The corporation then starts trading and generating income, and 10 years after the initial investment, I sell it. I have had a significant

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appreciation on the value of my stock, and I have a capital gain. But during those 10 years, I have not paid any tax. I have deferred it all the way out until the sale and have a back-end capital gain. Well, the law does not allow that anymore. If I invest in an entity that is essentially an offshore trading entity (a PFIC), I have to either elect to pay tax on the income currently, even though it has not been distributed, or be willing to pay an excise tax at the back end with an interest charge, which essentially equalizes things—treating the investment as though it had been a flow-through entity for the entire period I was invested in it.

Question: Are there any problems when using a hedge fund in a trust? Nesler: If you invest in a hedge fund on behalf of a trust, make sure that the trust document permits that type of investment. Most modern trust documents are written broadly enough to cover socalled alternative investments, but some older documents (and even some newer documents) are not broad enough. So, if you are a trustee investing trust assets in a hedge fund, make sure that you have the authority to do so and that you are complying with any and all restrictions.

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Understanding Recent Tax Law Changes Michael J. Serota Partner Deloitte & Touche Chicago

U.S. tax law changes that took effect in 2003 have reduced the marginal income tax rate, long-term capital gains rate, and qualifying dividend income tax rate—all of which have a significant impact on private client investors in hedge funds. But tax considerations for private client investors are not only restricted to tax rates; understanding other key factors, such as the requirements to qualify for the new reduced rates, is also important. These factors can guide investors in the questions they ask (or should ask) when conducting their due diligence.

or private clients, the tax and legal implications of investing in hedge funds have changed significantly since 2002. In this presentation, I will look at the source of those changes (the Jobs and Growth Tax Relief Reconciliation Act of 2003), offer a tax and accounting perspective on these changes, and provide thoughts on key factors to consider when investigating tax and legal counsel.

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2003 Tax Legislation Over the past several years, the U.S. Congress has been debating various areas of tax law: tax law dealing with shelter legislation, tax law dealing with tax rate issues on ordinary income and capital gains, and tax law dealing with deferred compensation. Interestingly, the 2003 tax act (the Jobs and Growth Tax Relief Reconciliation Act of 2003), which was passed by Congress on 23 May 2003 and signed into law on 28 May 2003, does not deal with deferred-compensation issues. Even though there has been a great deal of discussion on changing the tax benefits of deferred compensation, little has happened in that area. In addition, this legislation is not tax-shelter legislation. Furthermore, the 2003 tax act has nothing to do with states, although some state-level legislation has been passed. States are looking for ways to collect money from hedge funds either by creating fee-type structures (as New Jersey did) or by arguing that income is sourced to particular states. In February 2003, however, legislation was passed dealing with disclosure issues. So, whether you are a hedge fund manager, client, or advisor, the

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Schedule K-1s you get (or prepare) for 2003 will be much more complicated than they have been in the past because of this disclosure legislation. What, therefore, is the 2003 tax act about? It is about a reduction in marginal income tax rates to 35 percent for individuals, a long-term capital gains rate reduction to 15 percent for individuals (from 20 percent), and a dividend tax reduction to 15 percent. Note that all these provisions are for individuals. They do not apply to corporations, but they do apply to partnerships because partnerships (e.g., hedge funds) pass these tax attributes on to the individual partners. So, to the extent that a hedge fund trades in securities and those trades generate long-term gains after 5 May 2003, those gains will be taxed at 15 percent. To the extent that the hedge fund has qualifying dividend income, it will be taxed at 15 percent. To the extent that a hedge fund partner receives distributions of ordinary income and short-term capital gains from the hedge fund, they will be taxed at 35 percent. So, although these are all individual provisions, they are extremely important to hedge funds because hedge funds engage in trades that will incur taxes, which will be passed on to the hedge fund investors. Marginal Tax Rate Reduction. The marginal tax rate reduction is an acceleration of reductions in the 2001 tax act (the Economic Growth and Tax Relief Reconciliation Act of 2001). The new rate for the highest tax bracket is 35 percent. It is supposed to revert back to 39.6 percent in 2010, but nobody knows for sure what will happen.

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Understanding Recent Tax Law Changes Capital Gains Rate Reduction. The 2003 tax act deals with capital gains rate reduction. For those who are not familiar with U.S. tax law, net capital gains are the excess of long-term gains over shortterm losses. The capital gains reduction applies to gains realized after 5 May 2003. If an individual took gains prior to 6 May 2003, those gains will be taxed at the top rate of 20 percent. Thus, the difference between the top marginal tax rate and the capital gains rate has increased from 18.6 percent (the 38.6 percent marginal rate that had been in existence prior to the law change minus the 20 percent capital gains rate) to 20 percent (the new 35 percent marginal tax rate minus the 15 percent capital gains rate). Capital loss carryovers now provide less benefit as a result of the changes in the 2003 tax act. In prior years, capital losses could have been applied to longterm gains taxed at 20 percent or short-term gains taxed at 38.6 percent. Now, they are applied to longterm gains and ordinary income taxed at a lower rate. Also, it is not clear how passive foreign investment companies (PFICs) will report the split year, but at Deloitte & Touche, we suspect that PFIC reporting will be bifurcated (i.e., investors will get statements from PFICs reflecting the split at 5 May). So, PFICs will give investors the capital gains generated prior to 6 May and those generated after 5 May. Section 1256 of the tax code deals with regulated futures contracts that are marked to market. Thus, futures that are traded in the United States— nonequity index options and certain types of dealer equity options—are marked to market and treated as though they were 60 percent long-term and 40 percent short-term gains. What is uncertain is whether there needs to be a mark at 5 May, at the effective date of the legislation. Most accountants believe that the mark will still take place only at the end of the year, as would be consistent with legislation passed in 1997 when it became clear that there would not be interim marks. So, we do not expect that investors will see any marks as a result of the 2003 legislation, but they will at the end of the year. Dividend Tax Relief. The 2003 legislation is also about dividend tax relief. Qualifying dividend income (QDI) earned by U.S. individuals is now taxed at the same rate as long-term capital gains—15 percent. Note, however, that although the tax on dividends has decreased from 38.6 percent to 15 percent, a corresponding reduction in withholding has not occurred. For an individual who invests in an offshore feeder, the withholding rate that applies to U.S. source dividend income has not changed; it is still 30 percent. Thus, no change has taken place in the withholding regime as a result of the change in the taxation of dividend income (which does not ©2004, AIMR®

make any sense, but the law is not perfect). Also note that this dividend relief applies retroactively: It applies to all dividends taken in 2003. So, a 2003 dividend taken anytime in 2003 is subject to the 15 percent rate as long as it meets all the tests of being a qualified dividend. ■ QDI requirements. QDI applies to dividends declared by a U.S. public or private corporation. So, a dividend issued by a company that meets various tests is QDI and is subject to a 15 percent tax rate. QDI also applies to foreign corporations as long as they meet certain tests: They have to be either organized in a U.S. possession or eligible for comprehensive treaty benefits. The U.S. IRS recently issued a ruling that lists the countries eligible for comprehensive treaty benefits. As expected, the list includes the countries in western Europe, some of the countries in the Middle East, and most of the countries in Asia, Canada, and Mexico. Notably, Barbados is not on the list, and neither are the Netherlands Antilles, the former Soviet Union, or Bermuda. Dividend income will be a problem for those countries not on the list. Keep in mind that dividend income excludes dividends that investors might get from PFICs. Another requirement for dividend income to be classified as QDI is that the investor must hold common stock for 61 days and preferred stock for 91 days, and the stock has to be unhedged. An interesting question is whether investors in a hedge fund could ever get QDI from the fund. If the hedge fund manager has offset the long positions, in all likelihood, the dividend income that investors receive as a result of those long positions will not be available for QDI benefits. So, if an investor is both long IBM and short IBM and the investor receives a dividend on that long IBM investment, QDI will not apply. Other exclusions also apply. S corporations do not generate QDI, and dividends that a taxpayer elects to include as investment income do not qualify. An interesting issue surrounds substitute payments (i.e., payments made in lieu of dividends) on stock loaned. The IRS has said that substitute payments do not qualify. In other words, if your broker has lent your securities out to be used in shorting, any payment received for loaning the securities is not a dividend. Such payment may have been reported in prior years on 1099s or other statements received from brokers as being a dividend, but it is not a dividend. For 2003, brokers are required to use their best efforts to figure out whether the payments they report to their clients are in lieu of payments or dividend payments. For 2004, they are required to have systems in place that will guarantee that they can figure out whether the payments are in lieu of payments or dividend payments. Thus, for 2003, www.aimrpubs.org • 69

Integrating Hedge Funds into a Private Wealth Strategy when an investor receives a statement from his or her broker, whether it is a 1099 or another type of statement, the investor is entitled to rely on that statement if the statement says that it is a dividend unless the investor knows that it is not qualifying. For 2004, brokers will have to specify whether payments are QDI or not. Brokers under the legislation are required to use a lottery system to allocate QDI back to all investors. Tax exempts lend out their securities a great deal in order to get back the in lieu of payment. Tax exempts, however, were not intended to benefit from this legislation. The legislation was intended to benefit individual taxpayers. So, one of the ideas that has been floating around is whether a tiered system can be established that would allocate the QDI first to the taxable investors and last to the tax-exempt investors. This idea makes all the sense in the world and is consistent with the intent of the legislation. ■ PFIC exclusion for QDI. Under the 2003 tax act, working with PFICs has become more difficult because of the conversion of QDI to ordinary income. If a PFIC is invested in a security that would otherwise generate QDI but the PFIC distributes the income to investors (assuming the investors have made a qualifying fund election), that income comes through as ordinary income. It does not come through as a dividend. So, a negative arbitrage of 20 percent exists on any dividend income that the PFIC otherwise would have. The advice for investors in a PFIC is to go to the PFIC and find out whether a separate account or a separate type of special purpose entity can be structured that is a flow through for tax purposes, even if creating the account requires that the investor pay to have it done. If a significant amount of QDI is locked up in that PFIC, unlocking it will make a significant difference for the investor. In addition, because many funds of funds have PFIC investments, investors in a fund of funds might want to ask the manager whether and to what extent the fund is invested in PFICs and what steps are being taken to mitigate the negative ramifications of this QDI/PFIC issue. ■ Conflicts with QDI rules. The QDI rules pose some conflicts for the master-feeder structure. In the context of a master-feeder structure, the people who benefit from the securities lending are the investors in the offshore feeder. And the ones who want the long position or the QDI are the investors in the domestic limited partnership (LP). In a master-feeder structure, the securities lending income cannot be allocated to the offshore feeder for tax purposes and the QDI cannot be allocated to the domestic LP. Doing so would be contrary to the regulations dealing with partnership taxation. Thus, the master70 • www.aimrpubs.org

feeder structure might be split into side-by-side entities (a domestic LP and an offshore corporation) in order to maximize the tax benefits and also to get the securities lending income to the members of the offshore corporation. ■ Deferred compensation. In light of the new QDI rate, fund managers will have to reconsider deferredcompensation arrangements. No one knows what the ordinary income tax rates will be in 5 or 10 years. So, does it make more sense for a fund manager to take back his or her deferred compensation now, which comes in the form of a combination of QDI and long-term capital gains, when the rates are at 15 percent or to wait to take it back at an unknown rate 10 years from now? The answer boils down to a cost– benefit analysis and gets at risk and credit issues. Therefore, fund managers will be reconsidering their deferred-compensation arrangements, especially if their funds generate a significant amount of capital gains and QDI. ■ 475 elections. A 475 election is an election whereby the fund marks to market all of its positions and treats all gains/losses as ordinary income. Because of the new tax rates, we are often asked whether 475 elections still make sense. Our position is that they are a good idea when two factors are present: (1) low or little likelihood of net long-term capital gains and (2) high likelihood of continued taxable income in excess of book income. A fund makes a 475 election to avoid a book tax disparity. If a fund has significant book tax disparity and is unlikely to have long-term capital gains in the future, then the 475 election probably makes sense. We have also been asked whether the QDI rules still apply in the context of a 475 election. (The point being that if the fund has elected to mark everything to market and is thus treating everything as being sold, how can there be a holding period?) The answer is yes; the rules still apply. The securities are treated as sold only for purposes of the mark. They are not treated as sold for purposes of the QDI provisions. Important Points for Managers. Because of the 2003 tax act, funds will need to track pre- and posteffective-date capital gains as well as holding period and treaty requirements for dividend qualification. And the preferential taxation of dividends for U.S. individuals may impede tax planning for masterfeeder structures. The increased focus on after-tax efficiency of hedge funds and the new and increased reporting will create challenges for managers. Finally, fund managers ought to get in touch with their prime brokers, custodians, and administrators before the busy tax season arrives to make sure that they have systems in place to deal with these new tax issues. ©2004, AIMR®

Understanding Recent Tax Law Changes

Investor Due Diligence In this section, I will discuss some of the due diligence questions investors should ask from a tax and accounting perspective before they invest in a hedge fund. I am not by any means presenting an exhaustive list but, rather, the top things on my mind at the moment. One of the most important questions to ask is whether the fund has qualified counsel. At Deloitte & Touche, we often see funds that are set up by attorneys who lack experience in setting up hedge funds, which can be a big issue because documents may be crafted in such a way as to be a problem from a tax or accounting perspective. We do not see such problems with law firms that specialize in hedge funds. A law firm may be an outstanding firm, but if it does not specialize in hedge funds, then it should probably not be used as counsel to a hedge fund. The same issue applies to a hedge fund’s accounting firm: Is it a qualified firm? Having (or not having) a qualified accounting firm on the fund’s side can have a significant impact on calculations of taxable income and allocations to the investors, which ultimately affects the fund’s business. At the end of the day, the fund’s Schedule K-1s, financial statements, and legal documents represent the fund in the marketplace. If a fund has not done a good job of taking care of those documents, it will suffer. Thus, even if using a qualified law firm or accounting firm costs more, it is money well spent. Investors should also ask whether the fund is audited. Under no circumstances should investors invest in a fund that does not have audited financial statements. A fair number of funds reported in the newspapers as having blown up were simply not audited. Although an audit is not a guarantee that something will not go wrong, it is a reasonableness test. Another good question for investors to ask is how the fund’s tax and economic results have compared historically. If a fund has had taxable income in excess of book income on a constant basis, investors should understand why because it means investors are picking up a lot of up-front income—paying tax on the front end with a potential back-end capital loss, which is a bad result. Does the fund take the position that it is in a “trade” or “business” for tax purposes? That question

©2004, AIMR®

is important for investors to ask. It gets at the issue of the deductibility of expenses. If a fund can take that position and still take its expenses “above the line” for federal income tax purposes, investors will benefit because doing so will increase their after-tax return or prevent their after-tax return from being reduced as a result of having expenses that are not deductible. The fund cannot take this position simply because it wants to; it has to have the requisite facts and circumstances. Investors ought to obtain a copy of the fund’s prior Schedule K-1s and have them evaluated by their own counsel and accountants to see what the fund is doing. In addition, investors should ask whether there is state disclosure. I mentioned earlier that states are trying to ramp up their involvement with hedge funds, so investors should make sure they have adequate state disclosure, or at least ask about it. Asking whether the fund has PFIC investments is also important. If it does, investors should make sure that a qualified electing fund (QEF) election has been made. If the fund has investments in PFICs and has not made a QEF election, then investors could be subject to back-end deferred excise taxes and deferred interest charges, which can be a problem. How is taxable income allocated? Will a purchaser buy into unrealized gains? Does the fund equalize on redemption? These additional questions should also be asked. The point is that when investors buy into mutual funds, they can potentially be buying into unrealized gains and taking the dividends for tax purposes. Hedge funds, however, have the ability to allocate taxable income based on economics. So, investors need to know what the fund’s allocation methodology is. In addition, investors need to know whether the fund equalizes on redemption (either partially or completely). If an investor redeems and has economic basis in excess of his or her tax basis, the fund should be allocating capital gains to that investor and benefiting the remaining investors in the fund. It is a fairness issue. Furthermore, investors should ask whether the fund generates unrelated business taxable income (UBTI). Investors can also find an answer to this question by examining the Schedule K-1s. Finally, a related question to ask is when the Schedule K-1s have been distributed historically.

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Integrating Hedge Funds into a Private Wealth Strategy

Question and Answer Session Joseph H. Nesler Michael J. Serota Question: Starting in 2004, should investors refuse to lend their shares in order to get the 15 percent tax rate on dividends?

Question: Does the $5 million test hurdle for hedge funds apply to revocable trusts or irrevocable trusts or both?

Question: Because hedge funds are audited only annually, how do you gauge accuracy on a monthly mark-to-market basis?

Serota: It all depends on what the net economics are. The question is whether your marginal revenue from the securities lending is greater than what you would get from holding the security long and getting the 15 percent dividend tax rate. It is purely an economic analysis.

Nesler: Ordinarily, if the trust is a so-called grantor trust or a revocable trust—in other words, a trust that the grantor can terminate at any time—you don’t need to look at whether the trust itself has $5 million in assets. The real question is whether the grantor himself is an accredited investor. The grantor could be an accredited investor if he has $1 million in net worth or if he has had gross annual income in the past two years of at least $200,000 (or $300,000 with his spouse) and reasonably expects to hit that $200,000 level (or $300,000 with his spouse) in the current year. So, in the case of a grantor trust, you basically disregard the trust itself and look through to the grantor, and if the grantor is an accredited investor, then the trust will automatically be an accredited investor. For an irrevocable trust, however, the $5 million test does apply.

Serota: What you want to look for is a third-party administrator, record keeper, or prime broker. Having a third party involved is not a guarantee that the purported performance is accurate, but if you are receiving information from a third-party prime broker or custodian, for example, you know there is at least some verification. You could also ask to have the information audited semiannually or quarterly.

Question: Should an investor be concerned if a fund’s fee structure is too low relative to other funds? Nesler: I have run into some managers who believe that fee structures are too high, and even though they could charge what the market bears, they don’t. So, in some cases, you might be faced with a manager who, as a matter of principle, believes that he is charging a fair fee and does not think that he needs to charge more. In other cases, the low fee could result from someone who has had a hard time attracting money. If it is a small fund, a good question to ask is why the fee structure is lower than normal. As I mentioned earlier, investors can ask why a fee structure is higher than others, so it is fair to ask why a fee structure is lower. Question: Is an out-of-themoney call option on a stock considered hedged for the 15 percent tax consideration? Serota: No. If your option is out of the money, you probably have not substantially reduced your risk of holding that long position. So, your holding period on the long position should continue, and you should be OK. 72 • www.aimrpubs.org

Question: When using hedge funds in a private placement life insurance structure, are you now required to invest only in insurance-dedicated funds? Serota: If the product is private, you should not run afoul. What they’re trying to do is put you in the Section 1260 regime, which says that you are treated as the owner of the underlying hedge fund itself and the insurance product is really not there. Generally, if the product is not offered to anyone other than you, then you should be OK under the rulings. If it is offered to a larger audience, then you run afoul of those provisions.

Nesler: The only difficulty is that many onshore funds do not have third-party administrators. The general partner simply administers the fund itself rather than hiring a third-party administrator to do so. But it is becoming more common now for onshore funds to hire administrators because it gives investors a degree of comfort. So, in some cases, you simply won’t have that administrator, but if the fund has a prime broker, that’s just as good because it will also value the assets. Serota: There’s been some noise by at least one accounting firm about not providing audit services for funds that don’t have a thirdparty intermediary. As we move forward, given the environment that we’re in, the accounting firms, at least the larger ones, are going to require some type of third-party custodian or administrator between the fund and the accountants, just to add another level of verification. ©2004, AIMR®

Legal and Tax Considerations Question: Has the IRS issued opinion letters on structured products? Serota: There are opinion letters on different types of structured products. If you’re trying to develop a product that will provide you with deferral and/or conversion, you can still do that under the right circumstances. You should work with your accountants and attorneys to structure the product. Thus, it can still be done, but under very tight constraints. Would you ask for a ruling from the IRS in such a situation? Generally, no. You run the risk of the IRS turning down the ruling request. So, in a situation in which you put together a structured product, you will want to get an opinion from counsel. With this opinion, at least you get to the point at which you can take the position and feel somewhat comfortable that the product will work. But generally, you won’t request a ruling. Nesler: In addition, by asking for a ruling, not only do you risk the possibility of getting an answer you don’t want to hear but you also have a timing consideration. Getting a ruling is not done quickly. It sometimes takes years. Question: What are the various levels of opinion available on products structured as warrants, options, and so on, in hedge funds that move all the returns to the end date as capital gains rather than ordinary income? Serota: The question relates to a structured product and using a derivative as an intermediary investment for direct investment in a fund in order to generate a capital gain on the back when the product is ultimately sold. So, for example, you would buy a European-style option that could be exercised only at the back end; you would exercise it at that point and have a capital gain on the disposition. ©2004, AIMR®

You are generally going to get a “more likely than not” opinion from counsel. It depends on your level of risk tolerance as an investor. I am much more aggressive, personally, when it comes to dealing with an advisor and his or her own money than I might be in dealing with the fund itself. The fund is your livelihood, and you have more risk if something goes wrong with a structured product in the fund because those are your investors that you are affecting. When you are creating the product at the advisor level, it is for you or your partners and the advisor. So, as far as I’m concerned, if you want to be aggressive, be aggressive. But you don’t want to do something without an opinion. Certainly, you want to make sure you have a “more likely than not” opinion, and a properly structured product will at least get you a “more likely than not” opinion. Nesler: Of course, no opinion, even a clean opinion, is a guarantee. As long as the attorney who rendered the opinion has done so in a manner that’s not negligent, then even if the opinion is wrong, the attorney can’t be sued. And that’s even more the case in a “more likely than not” opinion. All the attorney is saying is that in her view as an experienced practitioner in the tax area, more likely than not this should be the result. But the IRS may take a different position. And that IRS decision will not affect the validity of that attorney’s opinion in the sense that it will not afford an investor the right to sue the attorney simply because the IRS took a contrary position. The virtue of getting the opinion is that the likelihood of being assessed any penalties or getting thrown into jail is very small if the IRS does take a different position. That’s the real protection. Getting the opinion doesn’t necessarily mean you’re going to get capital gains treatment, but it will prevent you from getting penalized.

Serota: And it also protects you in the sense that you know you have purchased a product that is at least plausible. Some people are plugging products with dubious economics, and the opinion will at least tell you that there’s some validity to what’s happening and it is not outside the realm of possibility. Question: Can you invest in a hedge fund via your IRA? Serota: Yes, but if you invest in a domestic fund that’s treated as a partnership for federal tax purposes, which most domestic hedge funds are, and if that partnership leverages through borrowing, you potentially get UBTI for the IRA. In other words, the IRA will get taxable income from that fund. It will have to file a tax return and so on. For that reason, most taxexempt investors don’t want to go anywhere near a domestic hedge fund that uses leverage. They prefer to invest in the offshore sister company or offshore feeder fund that feeds into a common master with the onshore fund in order to avoid the UBTI problem. Nesler: The only caveat to that answer is that you have to consider the cost of paying the UBTI for investing in the U.S. feeder versus investing in a foreign feeder and potentially losing any withholding that takes place on U.S. source dividend income. Even though you’ve paid a UBTI tax, investing in the U.S. feeder may very well cost less on an after-tax basis than investing in a foreign feeder that may have a significant withholding. So, you have to ask how much UBTI there is, how much has been there historically, how much leverage you use, and what your withholding is if you invest in a foreign feeder. Serota: You should also ask what your transaction expenses will be for filing a tax return and having your accountant figure this out. That’s another consideration. www.aimrpubs.org • 73

Integrating Hedge Funds into a Private Wealth Strategy The bottom line is there is no legal prohibition against investing in a hedge fund via an IRA. The question is whether you want (or would be allowed) to do it under the circumstances. Question: Would you explain further what a PFIC is? Serota: Suppose I wanted to defer taxation on some money indefinitely. I could put the money into an offshore corporation, which would not be a flowthrough entity for tax purposes, and get stock in the corporation. The corporation then starts trading and generating income, and 10 years after the initial investment, I sell it. I have had a significant

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appreciation on the value of my stock, and I have a capital gain. But during those 10 years, I have not paid any tax. I have deferred it all the way out until the sale and have a back-end capital gain. Well, the law does not allow that anymore. If I invest in an entity that is essentially an offshore trading entity (a PFIC), I have to either elect to pay tax on the income currently, even though it has not been distributed, or be willing to pay an excise tax at the back end with an interest charge, which essentially equalizes things—treating the investment as though it had been a flow-through entity for the entire period I was invested in it.

Question: Are there any problems when using a hedge fund in a trust? Nesler: If you invest in a hedge fund on behalf of a trust, make sure that the trust document permits that type of investment. Most modern trust documents are written broadly enough to cover socalled alternative investments, but some older documents (and even some newer documents) are not broad enough. So, if you are a trustee investing trust assets in a hedge fund, make sure that you have the authority to do so and that you are complying with any and all restrictions.

©2004, AIMR®