their sources of return.20 Similarly, more recent research indicates that certain factors (return drivers) help to explain AIS performance patterns.21Some go even further and argue that ‘generic’ systematic trading programs (with no discretionary or skill-based input) can replicate most strategies’ returns (and subsequently say that the high fees for AIS managers are not justified).22The current academic thinking on how to evalu- ate AIS returns is to include ‘style factors’ (e.g. option-like payoffs) in the set of performance factors rather than just explain AIS return based on other asset returns.23
The detection of specific performance drivers for AIS strategies with the help of quantitative tools such as factor models has been subject to intense discussion and research in the academic and the financial community in recent years. Hedge funds are now often classified as either ‘long biased’, i.e. primarily influenced by the direction of international bond and equity markets (‘return enhancers’), or non-directional attempting to be less affected by the direction of the major finan- cial markets (‘diversifiers’). But the statistical significance of AIS factors models has to date been rather low. This is partly due to the short time series available for research. Empirical measures for some AIS risk factors may not yet sufficiently describe the significant losses after ‘big events’ which are part of many strategies’
risk profiles. Most AIS professionals agree that qualitative reasoning has to sup- plement such quantitative analysis. Schneeweiss et al. in a recent publication provide a good summary of the discussion on sources of AIS return.24
A fund of funds can also be a more liquid investment than direct investments with single Hedge funds or Managed Futures. Furthermore, if properly managed, it can provide the security created by continuous monitoring of managers and portfolio and risk management. Therefore, investing in a fund of funds is the preferable route for new investors, institutional as well as private.25But the added value of a fund of funds is only realized if certain conditions are met. The fund of funds manager must have a complete understanding of the individual strategy sectors and their risks and correlation features, perform thorough due diligence on all managers and their respective ‘edges’, implement a system for continuous monitoring of open positions, and actively manage risk (see Chapter 7 for a more detailed discussion).
The structure of AIS investment products such as funds of funds can be quite complex and innovations change the industry continuously. Managing a multi- manager product requires expertise not only on the level of instruments and markets, but also in respect of legal and regulatory issues. The set-up of a multi- manager AIS investment vehicle involves a variety of different parties (see the discussion in Chapter 7 for more details):
1 Management company or fund of funds investment manager:The investment manager selects and monitors the individual trading managers and determines the legal and administrative structure of the investment vehicle. He usually receives a management as well as a performance fee.
2 Investment advisors/managers:The managers are hired by the investment manager and are responsible for the actual investments, either in his own fund or through a managed account.
3 Administrator:The administrator is responsible for registration and issuance of the shares, performing the necessary legal and tax tasks, calculation of NAV and performance fees, account administration, handling of subscriptions and redemption and the organization of audits.
4 Prime broker:Prime brokers provide for the global settlement, clearing and execution of trades done by the managers. They also provide credit lines for financing leverage and Short Selling capabilities. Furthermore, prime brokers often give the investment manager access to value added services like research reports and risk management tools.
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5 Execution brokers:The execution broker arranges the execution of trades, either over the counter or on an exchange. Most managers use several executing brokers in order to get best prices. A good part of the trades is usually executed through the prime broker.
6 Custodian:The custodian is the connecting piece between the broker and
the administrator. He tracks the receipts and payment obligations for subscriptions and redemptions, monitors the brokers and records the different transactions.
The number and variety of multi-manager AIS investment products is growing rapidly.26 They come in a variety of structures, the details of which depend on the chosen domicile, promotional issues (sales restrictions), required investment flexibility and tax issues. Many funds of funds are set up offshore, as offshore centres provide investors with tax benefits and relieve the managers of regulations on the use of deriv- atives, short sales and leverage. US fund managers primarily choose the nearby Caribbean islands (Bahamas, BVI, Cayman Islands, Bermuda, Netherlands Antilles), while Europeans select Luxembourg, Ireland, the Channel Islands (Jersey, Guernsey) and Switzerland (where regulations are usually stricter than in Caribbean countries).27 The actual location of the AIS portfolio manager usually differs from the fund domi- cile and is usually in the proximity of main financial centres (New York, London, Geneva, Zurich, Hong Kong, Tokyo, Frankfurt etc.). Today four general structures of AIS fund of funds investment vehicles can be distinguished: open-ended funds, closed- end funds, structured notes and managed accounts (see also Chapter 7 for a discussion of the different redemption policies of these fund of funds products).
Open-ended funds of funds with redemption periods ranging from one to six months are usually structured as limited liability companies in the USA and the Caribbean offshore centres, trust structures in the UK (including the Channel Islands) or some form of collective investment contract scheme in continental Europe (e.g.
SICAV in France and Luxembourg). Low liquidity (long redemption period) and lim- ited investment transparency are the main disadvantages of this structure.
Structured notes are designed to fulfil specific investor needs such as capital pro- tection, regulatory specifications, legal constraints and tax protection.28 They have become a common structure for multi-manager AIS products in Europe, often offered by investment banks in cooperation with fund of funds specialists. In Germany, for
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example, index-linked bonds, so called ‘Zertifikate’, are currently the most common AIS investment structures for tax and regulatory reasons (most AIS vehicles offered to German investors are based on some self-created ‘index’ made up of the selected man- agers). The customization to specific needs is the advantage of structured notes, but their disadvantage is that they often come with higher fees. A common form is a prin- cipal protected note which guarantees the 100% payback of the investment at maturity. Capital guaranteed notes are usually structured with a zero coupon bond or an option.29 For most structured notes the issuer provides for some liquidity in a sec- ondary market.
Other AIS products take the form of a closed-end investment vehicle, which often enjoys more regulatory flexibility than an open-ended fund. These products are wrapped as investment companies, which issue non-redeemable shares. After an initial offering period the investment company is closed for subscription and redemption and the shares are traded on an exchange. The problem of these invest- ment structures is that trading is often extremely low in volume and liquidity. This can lead to significant discounts of the market price to the net asset value (NAV).
Investors and allocators can structure their investments with individual man- agers through managed accounts, where the money is held in an account with an independent custodian or broker. Managed accounts structures offer the most flexible and transparent investment structure. But they require a significant mini- mum investment with each manager ranging from around $2 million to about $25 million. In a multi-manager investment set-up, a ‘fund of managed accounts’
requires a special legal framework to ensure that the individual managed accounts carry no liability from the other accounts.
Notes
1. A good discussion of the characteristics of AIS strategies (including their historical return properties) and an AIS classification scheme is presented by A. Ineichen in ‘In Search for Alpha’, October 2000 (updated and extended version
‘The Search for Alpha Continues’, September 2001).
2. Some authors present classification schemes which deviate in certain nuances.
I will try to indicate other schemes, wherever it is appropriate.
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3. For example, A. Ineichen in ‘In Search for Alpha’, October 2000 and ‘The Search for Alpha Continues’, September 2001.
4. See the article ‘A Primer on Hedge Funds’ by S. Fung and D. Hsieh for more details of AIS legal and regulatory issues.
5. See the book by Edwin Lefevre, Reminiscences of a Stock Operator(1923) for more details.
6. C. Loomis, ‘The Jones Nobody Keeps Up With’, Fortune, April 1966, p.237.
7. J. Rohrer, ‘The Red Hot World of Julian Robertson’, Institutional Investors, May 1986, p.86.
8. An interesting history of Hedge funds is presented in T. Caldwell,
‘Introduction: The Model for Superior Performance’, in J. Lederman and R. Klein, Hedge Funds: Investment and Portfolio Strategies for the Institutional Investor, Irwin Professional Publishing, New York, 1995.
9. Three surveys by Watson Wyatt/INDOCAM illustrate the increasing institutional demand for AIS products: ‘Alternative Investment Review Relating to the Continental European (respectively United States and United Kingdom) Marketplace’, Fall 2000.
See also report by Golin/Harris Ludgate, ‘The Future Role of Hedge Funds in European Institutional Asset Management 2001’. PricewaterhouseCoopers performed a survey among private banks in European with respect to the status quo and their expectations of AIS and their importance, ‘European Private Banking / Wealth Management Survey 2000/2001’. Other surveys with similar results were performed by Goldman Sachs/Frank Russell (2001 Alternative Investing Survey), Deutsche Bank’s equity prime services unit (see http://www.hedgeworld.com/news/read_news.
cgi?story=peop606.html§ion=peop), and the Barra Strategic Consulting Group FOHF (market survey, 2001).
10. An illustration of Hedge fund activities in the USA and Europe is presented in
‘The Hedge Fund “Industry” and Absolute Return Funds’, Goldmann, Sachs & Co.
and Financial Risk Management Ltd., The Journal of Alternative Investments, Spring 1999 and in ‘Starting a Hedge Fund – a US Perspective’ and ‘Starting a Hedge Fund – a European Perspective’, both published by ISI publications.
11. See, for example, ‘Hedge Funds – The Latest Bubble?’, The Economist, September 1, 2001, ‘The $500 billion Hedge Fund Folly’, Forbes Magazine, August 6, 2001, ‘The Hedge Fund Bubble’, Financial Times, July 9, 2001.
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12. For a more detailed discussion on bubbles in the financial world, see the paper by R. Shiller, ‘Human Behavior and the Efficiency of the Financial System’, and the book by H. Shefren, Beyond Greed and Fear: Understanding Behavioural Finance,Harvard Press, Boston (1999).
13. These are discussed in detail by E. Fama in a seminal paper: ‘Efficient Capital Markets: II’, published in the Journal of Finance, December 1991.
14. Standard finance proponents argue that market efficiency is not testable because such tests must be jointly accompanied by a test of an asset pricing model.
15. Most finance books cover the CAPM including its fundamental assumptions in great detail, e.g. F. Reilly and K. Brown, Investment Analysis and Portfolio Management, The Dryden Press, 1997.
16. The APT was introduced by S. Ross in the early 1970s and first published in 1976: ‘The Arbitrage Theory of Capital Asset Pricing’ in Journal of Economic Theory, December 1976.
17. See Chapter 10 of Investment Analysis and Portfolio Managementby F. Reilly and K. Brown for a good discussion of recent research results.
18. One example is the fact that stocks with high book to price value (BV/PV) have outperformed other stocks significantly in past years. It is still disputed whether this is a pricing anomaly or a risk premium. An argument raised by E. Fama and K.
French in their papers ‘The Cross-Section of Expected Stock Returns’ and ‘Size and Book-to-Market Factors in Earnings and Returns’ is that investors pursuing a strategy of buying high BV/PV stocks provide ‘recession insurance’ for other investors.
19. The risk free rate of return has nothing to do with a risk premium. In
economic terms, the risk free rate of return is the compensation to the investor for not persuing current consumption in exchange for higher future consumption.
20. See the seminal paper by W. Sharpe, ‘Asset Allocation: Management Style and Performance Measurement’ and the paper by E. Fama and K. French ‘Multifactor Explanations of Asset Pricing Anomalies’.
21. See the following articles for a further discussion: T. Schneeweiss and R. Spurgin,
‘Multifactor Analysis of Hedge Funds, Managed Futures, and Mutual Fund Returns and Risk Characteristics’; B. Liang, ‘On the Performance of Hedge Funds’; W. Fung and D. Hsieh, ‘Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds’; W. Fung and D. Hsieh, ‘Benchmarks of Hedge Fund Performance:
Information Content and Measurement Biases’; W. Fung and D. Hsieh, ‘The Risk in
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Hedge Fund Strategies: Theory and Evidence from Trend-Followers’; V. Agarwal and N. Naik, ‘Performance Evaluation of Hedge Funds with Option-based and Buy-and- Hold Strategies’; F. Edwards and M. Caglayan, ‘Hedge Fund Performance and Manager Skill’; See also the summary discussion of different articles on this subject by A. Ineichen in ‘The Search for Alpha Continues’, pp.93–95. An interesting study on return profiles of Hedge funds is also the following: G. Amin and H. Kat, ‘Hedge Fund Performance: 1990–2000: Do the Money Machines Really Add Value?’
22. See the article ‘Hedge Funds Placed Under the Microscope’ by G. Polyn in Risk Magazine, August 2001, and references therein (especially the study by the International Security Market Association). Academic research has also focused on the direct
replication of the AIS with generic trading models, see e.g. the discussions by T.
Schneeweiss and R. Spurgin in ‘Trading Factors and Location Factors in Hedge Fund Return Estimation’, T. Schneeweiss and H. Kazemi, in ‘The Creation of Alternative Tracking Portfolios for Hedge Fund Strategies’, as well as the paper by W. Fung and D.
Hsieh, ‘The Risk in Hedge Fund Strategies: Theory and Evidence from Trend-Followers’.
23. A promising approach of a ‘style factor model’ is presented by A. Weismann and J. Abernathy in the article ‘The Dangers of Historical Hedge Fund Data’, in Risk Bucketing: A New Approach to Investing, 2000.
24. ‘Understanding Hedge Fund Performance: Research Results and Rules of Thumb for the Institutional Investor’, Lehman Brothers Publication, Dec. 2001.
25. For a detailed discussion of the characteristics and value added of fund of funds, see also the contribution by A. Ineichen, ‘The Search for Alpha Continues – Do Fund of Hedge Fund Managers Add Value?’
26. A good (but somewhat outdated) overview of the different structures is presented in Hedge Funds and Managed Futuresby P. Cottier, p.55.
27. A discussion of the different legislations for Hedge funds is presented in ‘The Capital Guide to Alternative Investments’, ISI publications, 2001.
28. See the following articles for more details: P. Astleford, W. Yonge and R.
Edwards et al. and I. Cullen in ‘The Capital Guide to Alternative Investments’, ISI Publications, 2001; P. Watterson, ‘Offering Private Investment Funds in the Capital Markets’, Alternative Investment Quarterly, October 2001, p.43.
29. For an interesting discussion of structured AIS products, see the article ‘French Fight over Hedge Fund Products’ by N. Dunbar in Risk Magazine, February 2001.
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C H A P T E R 3
Alternative Investment Strategies:
Hedge funds and Managed Futures
In this chapter each AIS sector is discussed in terms of its investment strategy, sources of return and risk characteristics. In order to acquaint the reader better with the strategies, realistic examples are provided.