and gained wide public attention through an article about Julian Robertson’s fund in Institutional Investors magazine in the mid-1980s7 and through the British pound opting out of the European Currency System in 1992, which, it is widely believed, was caused by George Soros’ ‘Quantum’ Hedge fund (and which created large profits for ‘Quantum’).8
Futures predated equity markets, but it was not until the late 1960s that the use of Futures and other derivatives emerged within diversified trading strategies.
Managed Futures strategies were born around the same time as Hedge funds.
Richard Donchian created the first Futures-based investment program in the same year (1949) as A. W. Jones launched his first Hedge fund. Today the distinction between the two is somewhat blurred and some actually no longer distinguish Futures from Hedge funds. In 1965, Dunn and Hagitt started trading commodity Futures using technical trading systems (they also offered the first offshore commod- ity pool in 1973). A first boom in Managed Futures investment programs occurred with the introduction of financial Futures in 1972 and the increasing availability of computing power in the 1970s. Most of the investment programs were based on technical trading and charting systems. Managed Futures quickly came to be viewed as an interesting alternative investment class with attractive returns uncorrelated to returns in equities (which were rather modest in the 1970s). Traditionally, Commodity Trading Advisor (‘CTA’) funds are distinguished from Hedge funds on the simple notion that they are limited to trading primarily Futures contracts and that they are registered with the CFTC and comply with its regulatory rules. But nowadays, many CTAs also trade in OTC securities markets, while Hedge funds also use Futures as essential risk management tools (some Hedge funds are or used to be registered with the CFTC, e.g. Long-Term Capital Management – LTCM).
The AIS industry recovered strongly from problems related to the rapid increase of interest rates in early 1994 and the crisis following the Russian Bond default and the liquidation of LTCM in 1998. The time period after 1998 can be referred to as the
‘institutionalization phase’. The AIS industry’s growth in 1999–2002 was enormously supported by falling equity markets and the ‘NASDAQ crash’. The AIS industry is now so far developed that many investors consider it as an asset class itself. On the demand side, due to the attractive risk–reward characteristic as well as their low cor- relation to traditional investments, institutional investors have increasingly expressed
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interest in AIS.9On the supply side, the AIS industry has been and will continue to be a lure for the most intelligent talents in finance. The smartest finance professionals and most promising investment ideas are attracted to an industry that offers greatest flexibilities for the implementation of investment and hedging strategies together with a very high level of monetary compensation. Most banks and other large finance insti- tutions have begun to offer a diverse range of AIS investment structures,10 as they come to view AIS as a new and increasingly profitable business segment.
The question, whether AIS constitutes an asset class in itself or whether Hedge funds and Managed Futures only extend the range of investment strategies within certain existing asset classes, is subject to debate and is mostly a matter of perspec- tive. Investors increasingly consider AIS as a separate class in their asset allocation process (sometimes together with Private Equity investments). On the other hand, Hedge fund and Managed Futures programs do not trade any particular new assets or instruments but rather execute certain investment strategies within a set of exist- ing instruments and asset classes. They can be seen as the active counter-party to passive (i.e. index-linked) investment strategies in a ‘core–satellite’ portfolio set-up.
Sceptical market participants and investors have recently compared the devel- opment of Hedge funds with the technology bubble in the 1990s and predict that the current AIS euphoria will similarly end in tears.11In the most simple sense, a investment bubble is a phenomenon that builds up when expectations skyrocket and everyone does the same thing at the same time.12 The heterogeneity of AIS clearly contrasts with historical bubbles such as the Dutch tulip mania in the 17th century, the US equity markets in the late 1920s, the Japanese stock market in the late 1980s or the internet hype in the late 1990s. The AIS industry covers a very broad range of asset classes and favourable and unfavourable market environ- ments deviate strongly across strategy sectors. Economic developments, political events and changes in the market environment create and destroy different profit opportunities for different strategies. The AIS industry in its entirety is sufficiently well diversified to deal with extreme market circumstances.
The opposite view is that Hedge funds are a new asset class that has a legiti- mate place in every investment portfolio. The main argument underlying this view is that AIS have strong absolute returns and low correlations to traditional asset classes. But this might turn out to be new wine in old wineskins. A few years ago
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investing in emerging markets was marketed as a new way of decreasing overall portfolio risk. But experiences in the 1990s (Mexico, Thailand, Russia) have aligned the hype with reality. The diversification benefits of AIS might also be overestimated, as the AIS industry has had a long equity bias in recent (equity bull market) years and it is debatable whether the AIS industry can decouple com- pletely from global economic trends. Further, given the strong inflows into Hedge funds, one has seriously to ask whether return expectations are decoupling from reality. Lower absolute Hedge fund performance achieved in 2000 and 2001 may help gradually to align expectations with reality. AIS investing will increasingly require strong skills on the side of the allocator (fund of funds manager, direct investor) in order to realize the benefits of Hedge funds and Managed Futures while avoiding excessive risk.
2 ■The Universe of Alternative Investment Strategies
Macro 12.9%
Managed Futures 5.3%
Convertible Arbitrage 2.8%
Event Driven 10.9%
Relative Value 11.1%
Equity Non-Hedged 15.9%
Emerging Markets 3.2%
Distressed Sec.
2.7%
Equity Hedged (L/S) 29%
Equity Market Timing 0.7%
Equity Market Neutral 5.2%
Short Selling 0.1%
Reg D 0.4%
FIGURE 2.2■AIS asset allocation by strategy sector
Source: Hedge Fund Research
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Figure 2.2 displays the distribution of how assets are approximately invested in the different sectors (as of October 2001). Long/Short Equity is the dominant sector with more than 40% of all AIS assets invested in this strategy sector (Equity Hedged 29% plus Equity Non-Hedged 16%), followed in roughly equal size (11–13%) by Event Driven, Relative Value and Global Macro strategies. Futures strategies and Equity Market Neutral each take about 5%, Convertible Arbitrage, Distressed Securities and Emerging Markets about 3% each. Convertible Arbitrage and Equity Market Neutral are Relative Value strategies, but they are counted sep- arately here. Other strategies like Short Selling, Regulation D and Equity Market Timing fall below the 1% range. Note that these numbers depend on the classifi- cation scheme chosen (in this case by Hedge Fund Research).