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FL, Aima: Perhaps to start with it would be helpful if I set the scene. Hedge fund assets under management globally are estimated at around $1 trillion. In Europe, 228 funds were set up last year that raised $20 billion of new money. Europe today is growing faster than America and, in turn, Asia is growing faster than Europe. So let’s first look at the positioning of hedge funds: what do we know about the investor base? Barry why don’t you go first?
BB, Deutsche Bank: Well, the volume figures are instructive. That $1 trillion represents a 10-fold increase over the past decade, and it’s more than a doubling since the 1998 crisis. Interestingly, less than half of the growth has been from asset inflows: 55% has been a result of performance. The number of funds has also grown rapidly with about 6,300 managers now in existence. According to an internal survey we carried out, about 55% of those are funds of funds. Of the remaining 45% the largest sectors are 15% family offices, 7% banks. In terms of assets, the funds of funds represent around $300 billion, with the top 50 controlling $210 billion of investments.
The direct institutional investment has been driven by two factors: first, asset/liability gaps in the pension side. Last year, despite the rally in stock markets, S&P500 pension underfunding grew from $212 billion to $259 billion. We suspect it’s only going to get worse. Second, the institutions are following success stories such as the endowments of Harvard and Yale, both of which have a very high proportion of assets dedicated to alternative investments.
Their 10-year records – annualized returns of between 14% and 16% – have given a lot of institutional and academic gravitas to the idea that these belong as products within an institutional portfolio. And we’re beginning to see that in Europe as well: recent surveys show that 47% of the 73 largest pension institutions in Europe are intending to or have made investments into the alternative asset class.
OK, Permal Investment Management: Barry’s last comment raises the question of whether hedge funds are a separate asset class or a portfolio component. My view is that how they are viewed is a learning curve issue. Those new to hedge funds treat them as a separate asset class to be handled with care. They start with 1% or 3% or 5%, monitor that position and build structured products around it to prevent accidents.
People who have had more experience and are further up the learning curve view hedge funds as a portfolio component – as a superior way of investing in traditional investments not as an alternative set of assets. Private clients who have been exposed to hedge funds for more than a decade would very much view hedge funds as core and not as a separate asset class
AP, CSFB: I agree. The questions we are asked by our clients about risk imply that institutions are treating it as a portfolio component. They are now looking beyond the investments and strategies and performing principal component analysis themselves to try to isolate their fundamental risks. This is so they can integrate those risks into their investment portfolio.
DE, Société Générale: This raises the question of whether it is sustainable for an institution to consider alternative investments as part of its portfolio as any other type of investment. In other words, once people move from the 5% that Omar mentioned to, say, 25%, then how will the industry cope? Is there a capacity constraint?
BB, Deutsche Bank: I think the answer to that is that the personal economics of running a fund are very good so there is no lack of people who’d like to do it. Also it’s a very Darwinian space and so the biggest challenge the capacity constraint creates for the institutional investor is to force them to make investment decisions much earlier in the life cycle of a manager than previously. Today if an investor wants exposure to the hedge fund sector it often has to be willing to forgo the requirement for a long-term track record.
TB, UBS: Just to bring the private investor into this: private investors are the natural investors in hedge funds, especially given that many hedge funds were originally set up by wealthy families. And whereas one might think institutional investors are much more sophisticated just because they are large, it’s the private investors who have been investing their own money in hedge funds for years who have really taken the trouble to understand them.
We would never consider hedge funds to be an asset class. In our view they are simply a business model that enables investors to manage money in a far more sophisticated way – able to hedge out the risks to which you don’t want to be exposed and to take on very specific risks where you see opportunities. Given that, it follows that for a private client our job is to look at the overall picture, understand their needs and what it is they’re trying to achieve, and then to advise them in the creation of a customized hedge fund portfolio around those objectives, to the extent that it makes sense and is suitable for them, asset class by asset class. In particular we take into account downside risk potential and liquidity requirements.
For example, some investors might want to take on a highish degree of equity market risk, but to take the edge off the potential level of volatility at the same time. For them, longer-bias equity hedge funds make sense. Others might want a lower level of volatility altogether, in which case the equity hedge fund component of their portfolios would tend more towards neutrality.
That exemplifies how hedge funds are not an asset class; they are just a different way of accessing a particular asset class. That is a very important distinction, and private investors very much understand it, whereas I’m not so sure many institutions do.
BB, Deutsche Bank: I think that’s right.
TB, UBS: If I could just make one other point: in previous times, say the 1970s, investment managers really did buy stocks that they liked, rather than constructing portfolios around equity benchmarks. Then, the weight of money and the activity of the consultants pushed the investment management process to the benchmark and introduced the concept of tracking error. The way we see hedge funds now is that the investment process is coming full-circle, back towards absolute return.
However, the hedge fund model makes use of more sophisticated financial instruments, such as derivatives, in order to achieve more efficient use of capital and more precise access to trade ideas.
RM, Alternative Investments: I think this is all evolving tremendously quickly. But you are right: investors who get to be knowledgeable view it as an investment style and no longer as an asset class. It’s a way to make money, it’s a way to be opportunistic, it’s a way to take advantage of a particular market or a particular style. And I think this is a very important distinction that one has to make: if you buy a hedge fund, you buy a style, you buy an ability, a particular skill-set, to make money in a given context.
M Barry Bausano (BB) Managing Director, Global Head of Hedge Funds, responsible for all aspects of Deutsche Bank’s hedge fund coverage, including allocation of sales coverage, credit, legal, infrastructure issues, and fund launch consulting.
Tim Bell (TB) Executive Director, UBS Wealth Management, and responsible for establishing their hedge fund business for private investors in the UK.
David Escoffier (DE) a Managing Director, SG Corporate and Investment Banking and Head of Equity Derivatives for the UK and Northern Europe at SGCIB London.
Omar Kodmani (OK) CFA, Senior Executive Officer, Permal Investment Management Services Limited, responsible for reviewing and monitoring the activities of the Permal Group’s offshore investment activities as well as asset gathering initiatives.
Florence Lombard (FL) Executive Director, The Alternative Investment Management Association (Aima). She is responsible for day-to-day management as well as the development and implementation of projects in the areas of education, research and regulation.
Régis Muletier (RM) Chief Executive Officer and Co-Chief Investment Officer of Alternative Investments SA, a company that he co-founded in 2000.
Dr Anthony Pesco (AP) Managing Director, Head of the Fund Linked Products Group, Credit Suisse First Boston, and responsible for developing, distributing and trading structured alternative investments to all Credit Suisse Group clients.
Evan Salway (ES) investment manager responsible for alternatives for Baer’s London private client asset management company.
FL, Aima: Evan?
ES, Bank Julius Baer: I’d like to pick up on some of the points that Tim makes, because I think the difficult thing on the private-client side is education.
For a relatively uneducated private client, hedge funds are just an asset class, because for them it’s something that has risk/return characteristics that fit in a particular box or, if they are a bit more sophisticated, then it’s another product that’s added into their portfolio, perhaps to provide them with different correlation characteristics to their traditional equities or bonds.
If they were sufficiently sophisticated, I absolutely agree that they would view it as a way of investing and it wouldn’t then be an asset class. But the way I’ve found it easiest to explain to private clients is to describe it in terms of risk/return.
Before we started we were talking about Markowitz analysis. Well, everything I do with regards to alternatives and hedge funds I do bottom up on that basis. I break down hedge funds into the various different strategies and combine and optimize portfolios. I’d be interested to see the results other people get, because I think in a lot of instances you could make an argument to say that 100% of your money should be in hedge funds, and this obviously picks up on the capacity point that came up earlier.
BB, Deutsche Bank: This takes us nicely into the next question, which is: single manager, fund of funds or a multi strategy fund? Evan raises an interesting question and our analysis shows a couple of things.
There is pronounced statistical cyclicality of performance within sectors; there’s very elusive performance persistence for managers within a specific sector; and there is a fairly distinct correlation amongst sectors. Let’s focus on the cyclicality issue first. If you breakdown the sectors, as Evan described, you can do it into as few as seven and as many as 15, depending on how finely you want to analyze the differences.
There is a pronounced two- to four-year performance cycle within sectors. Importantly, counter-cyclicality is exhibited between the mean-reverting and trend-following strategies. So, for example, the strategies that can be replicated in financial markets by long straddle positions – which would include managed futures, macro et cetera – tend to be contrapuntal with fixed-income relative value, long/short equity and some of the other arbitrage-driven strategies.
Second, we’ve done some internal statistical work on the persistence of performance between managers within a sector and there’s good and bad news there.
Taking six-month performance windows over a multi-year period, the odds that a manager who’s in the top decile of his specific strategy maintains that position over the next six and 12 months is between 10% and 30%. Unfortunately, performance persistence among the bottom-ranked managers is much higher. If a manager performs in the bottom decile of their strategy sector, the odds are better that they stay in the bottom decile. So performance persistence is exhibited more strongly on a statistical basis among the bottom performers than the top performers. Additionally, the difference between the best and worst performing funds within a specific sector tends to narrow, but remain positive over time.
Finally, onto the issue of correlation.
Among sectors correlation is pretty high, and if you look at the funds across performance cycles, you will observe that despite obvious correlation among sectors, there are also divergences on a cyclical basis.
A correlation matrix among strategies reveals high correlations exist among trend-following strategies and mean-reverting strategies. Optimal portfolio constructions would therefore include strategies that are weakly correlated to each other and counter-cyclical. Finally, there’s the macro-economic issue that we are now in a very low yield environment with highly compressed credit spreads, highly compressed emerging market spreads and low volatility. There are many strategies that tend to underperform when these conditions reverse. Consequently, one has to be active about ensuring that your portfolio holdings reflect your view of what macro-variables will prevail in the upcoming holding period.
RM, Alternative Investments: The cyclicality you mention is a key driver. If you look back to the 1990s, the typical length of a cycle was somewhere between three to five years. Today it can be as little as 12 to 18 months as the capital available to eliminate market inefficiencies is so much larger.
Take the example of the distressed managers: they were hit in June and July of 2002. From September 2002 through January 2004, it was the sector to be in, and now again people are looking to reduce significantly exposure to it. So you have windows of opportunity smaller than 18 months. Add the variability of performance and you are forced to shift allocations much more dynamically than was the case in the past.
I would also like to make a small comment in the asset class versus investment style debate. If you look at the performance of distressed debt managers last year, you had funds that delivered over 100% returns and others that barely exceeded 10%. Hence it is difficult to talk of an asset class because an asset class typically has a relatively consistent behaviour in terms of risk and return. Here you have an example of a strategy where the distribution of returns is so wide that you can’t really define it as an asset class.
FL, Aima: What about the points raised in terms of changes in allocation patterns and more dynamic changes in strategy?
TB, UBS: Well, remember that the funds themselves understand these changes and the need to respond to them. So well-known hedge funds from a background of merger arbitrage have successfully transformed themselves more into event-driven funds where exposures include distressed and special situations, but these are utilizing the skills they’ve got, which are principally legalistic. And funds from a background of convertible bond arbitrage have skills that lend themselves naturally towards areas such as capital structure arbitrage, volatility trading and other forms of credit analysis.
FL, Aima: Omar, have you seen that? Permal is an established fund of funds with around $15 billion under management. How has the demand evolved? What types of products are of interest to investors today?
OK, Permal Investment Management Investors: are asking for different things at different times. I think during the three-year bear market they wanted 10% to12% low-risk annual returns, and after 2003 they turned around and wanted something with much higher upside. What that meant in the general marketplace of funds of funds in 02/03 was that they had so many offsetting managers and strategies in their basket of funds that they ended up with pretty mediocre returns – certainly lower returns than hedge fund indices and certainly much lower than could have been achieved by just being long equities.
And this highlights part of the problem with treating hedge funds as an asset class: a common first choice for institutions investing in hedge funds for the first time is a global multi-strategy fund. But actually that is an incredibly abstract animal, because you have very low risk global multi-strategy funds and much more directional ones, and the overall average may be pretty dull in terms of returns.
Investors now realize that funds of single strategy funds are a better way to achieve what they want. Our response is to unbundle what we offer so that clients can choose the component parts that make sense.
BB, Deutsche Bank: Omar makes a great point here, which probably deserves attention, which is that there is a very distinct food chain in the fund of funds world.
At the low end are the start-up funds of funds with insufficient capital and inadequate access to managers. These are followed by the friends-and-family static portfolios that did well historically, but might not be able to replicate the process that brought them success. Then there are the institutional providers that offer bulk access to the asset class but which have the drawback that Omar described of reverting to the mean and diluting returns.
At the higher end of the value-added chain are the single-strategy multi-manager funds who build a basket of the best performers within a specific sector but require you to do your own overall portfolio construction. And at the highest end of the value added chain are the high-end multi-strategy funds of funds that actually do the portfolio construction optimization and reweighting and risk attribution work for you. FRM would be a good example.
DE, Société Générale: Omar touched on a real trend in the industry. You have two things that are happening with multi-strategy funds: the first we have just talked about but the second is that managers of funds of funds are now doing tactical allocation much more actively than before.
In the past, people did not want tactical allocation – to switch allocations often. This is changing big time. Now all the large funds of funds are asking people like us to create indices that they can use to switch very fast from one strategy to another. I think this adds a lot of value, because, as a fund of funds, you are using your strength in analyzing the trends of a particular strategy and now you have the tools to overweight that strategy quickly.
FL, Aima: Tony, any comments?
AP, CSFB: Well, we are also being asked to decouple our multi-strategy multi-manager portfolio into its component parts and are trying to find ways of providing efficient ways of putting them together and giving the end-investor the flexibility to weight and re-weight. I think that’s a big part of the future in terms of structuring.
OK, Permal Investment Management: I would like to say one thing because it ties back to something that Tim said earlier.
Tim presents the case to clients, private clients, that long/short or hedge fund investing is a return to the old-fashioned way, non-consensus, non-institutional, non-consultant way of investing. I agree with him, and that’s one of the great things about it, but unfortunately I think we’re turning a corner now where hedge funds too will become institutionalized and consultant-driven. It’s not happening yet, but the trend is there.
I think the capacity question will be addressed by a market adjustment: a lot more people will change their organizations into so-called hedge fund players and the lines between traditional firms and hedge fund firms will become more and more blurred.
DE, Société Générale: Are you implying that the quality of the returns and the quality of the funds will actually go lower?
OK, Permal Investment Management: It’s possible.
BB, Deutsche Bank: Clearly the capacity constraints manifest themselves first in the highly leveraged minute derivative arbitrage strategies. If the strategy of the fund is to make 50 basis points levered 20 times to give you a 10% return, then as they grow in assets under management the more opportunities are constrained by the depth and liquidity of the underlying financial markets. The more the manager focuses on pure directional plays, the less absolute market exposure is required to generate the target returns and consequently capacity is less of an issue.
ES, Bank Julius Baer: There is another point here: the hedge fund universe tends to expand in line with opportunities. So there is a huge focus towards US equity long/short and much less attention on Asia because the opportunity set in the US equity market is much larger than it is in the Asian equity market. If we’re moving into a period of stronger equity markets, with more equity issuance, then as the underlying markets grow, so will the hedge fund universe itself and new managers will come through.
Also, I think we are at a turning point. In 20 years’ time people are going to look back and say: “So, previously we managed money by just going long the performing asset and we didn’t short the non-performing asset. Well that was silly.” In 30 years’ time everyone will be a hedge fund manager in one way or another and as that happens the capacity will come with it.
FL, Aima: Capacity is being created as new funds emerge too. What are people’s views on these?
TB, UBS: We divide them into three. First you have the new funds coming from existing platforms, and those platforms may be well-established hedge fund boutiques, hedge funds from more traditional “long only” houses, or, indeed, simply a new slant on an existing fund offered by a well-established firm. These are very attractive from the investor point of view as we know the firms already, we understand the operating platform and the risk controls, and financial viability is generally not in question. It’s usually a low-risk approach.
Second, you have the demonstrably skilled hedge fund managers who have come out of a successful fund and who have worked together for a long time in the hedge fund business. This group generally has no problems in raising money at the outset: they know who the investors are and have worked with them for a long time. They tend to reach financial viability either at launch or within the first two or three months, and may only remain open for a matter of months. And the third category is typified by the long only manager from one firm who gets together with a trader from another firm, who might be good friends or have had a broker relationship, but who have never worked together before.
This latter group will always struggle to raise money because they do not have any track record in the hedge fund industry, no experience of working together, and really everything for them is an experiment.
Investors will feel no need to rush into such funds, as a result of which they will sweat it out for 12 months or so, hoping that they can get by on “friends and family money” in order to build a sufficient track record. It’s a very expensive process and many of these funds, sadly, do not make it.
The important thing is that the track record attaches to the individuals rather than the fund. Just as we expect our hedge fund managers to invest with conviction, they in turn should expect us to invest in them with conviction and not expect that hugely lengthy track record. So when a private investor says to me “I only want to invest in hedge funds with a five-year track record and a minimum of a billion under management”, the first question I ask them is “Why?”, because to constrict an entire portfolio in this way makes no sense at all.
FL, Aima: Lets move on now to structuring issues and the latest developments in that area. Anthony, would you like to kick off on that subject?
AP, CSFB: Sure. Structuring means two things: one is providing market access, providing wrappers on underlying asset management vehicles to give investors market access. The second kind of structuring is re-engineering risks and dialing the risk to what investors are asking for.
Investors interested in hedge funds, in multi-strategy, multi-manager funds, started off wanting protection, so structuring desks created principal-protected investments. As people have gotten more comfortable with hedge funds and as rates have come down, those investors are increasingly moving away from that notion of principal protection and asking for leveraged structures. However, new investors into the asset class are still interested in protecting their investments.
The most interesting development is more of a philosophical development: providers of structured investments are now starting to realize that what they’re selling are investment products. That means the underlying investment products need to perform and the structure or wrapper is somewhat secondary. So now structuring desks spend a lot of time getting not only knowledgeable in terms of the financial engineering, but also closely aligning themselves with asset managers, both internal and external, and coming up with structures where the underlying asset management product is high performing and amenable to structuring. The institutions that have an integrated asset management and structured products platform will have the competitive advantage in the future as asset management and financial engineering both become critically important in the success of the product.
Investors are asking not only the underlying providers of the asset management products, but also the providers of the structured products, to distinguish themselves by offering alternatives to multi-manager, multi-strategy underlyings. That’s where we get back to the decoupling. Investors increasingly want structured product providers to offer very focused products where investors are given the ability to do the asset allocation themselves.
Structured product desks will need to create an infrastructure and an array of products that give investors the ability to do asset allocation, to be able to rebalance and reallocate across strategies.
We’ve become accustomed to offering structures on multi-strategy multi-manager funds but I think the world is changing. We need to adapt to these new market conditions and start giving investors what they really want, which is the ability to do asset allocation themselves.
DE, Société Générale: I wouldn’t be as drastic as that. I totally agree that the typical mixed strategy can be boring for some investors. Why? Because those investors began investing in guaranteed notes five to seven years ago, they’ve been educated by the large funds of funds and they are expecting more. But though there have been some fashionable products, such as the CTA-linked notes popular last year and at the start of this year, still the bulk of the interest is coming from multi-strategy. At least at SocGen we don’t have a huge demand for only single-strategy or mono-manager product.
One of the strongest trends that we have seen is the shift toward leveraged product. Leverage is not new, especially in this industry, but for us demand really picked up in 1998 and 1999 from the US with family offices. At the time European and Asian investors were still doing guaranteed structures and that’s how they learnt the trade. What is really interesting is that over the past 18 months, all the European investors have been asking for leverage and high levels of leverage. The big question is will this continue?
TB, UBS: The demand for leverage is partly a function of the hedge fund industry having reduced gross exposure and therefore volatility in response to the bear market and also of course a function of the cost of borrowing. Low interest rates tend not to favour guaranteed products although sterling-based products do have an advantage with the much higher interest rates.
BB, Deutsche Bank: Yes and I would say this is an issue of structuring’s own making. If we are very successful in building an optimized portfolio with very low draw-downs, very few down months in aggregate and low volatility, then the result is that the absolute return also goes down. So, as an investor, do you want a 30% return with 15% vol or a 10% return with 2% vol levered three times? The sophisticated answer is: “Of course I’d prefer the latter as it’s a 30% return, with 6% vol.”
OK, Permal Investment Management: Now, we’ve talked about some of the good points in structuring but it would be interesting I think to identify some of the not so good points. Structuring creates products for investors who can’t buy a hedge fund of funds directly but can buy one inside a bond. That is fine. But there are negative ramifications. One is the potential disintermediation of investor and manager. Now, on the one hand, that’s good because it’s efficient – the manager doesn’t have to worry about managing the relationship with the investor. On the other hand, something is lost.
Another possibly negative point is that many managers actually change the way they manage money in order to qualify for PPNs [principal protected notes] and structured products. That’s a very delicate thing, because you’re now changing the quality and nature of how you invest in order to fit somebody else’s guidelines. But I have noticed that managers who do provide underlyings for structures often provide portfolios which are not that exciting or robust, but have the low vol objective which, if levered up, can provide something reasonable.
My final point is probably the most sensitive: is so much structured money coming into hedge funds that it’s creating a new kind of risk in the marketplace? Before, the majority of investors did not use structured products and were investing from conviction. Now, they are more common and they can contain trigger events which cause significant deleveraging in them, which is not a matter of conviction any more, it’s a mathematical formula. Is this a factor in the market?
AP, CSFB: Well, it’s very hard to be just a structured product provider these days. Investors really do want to speak to the portfolio managers; they’re pretty savvy and they want to talk to the guy actually making the investment decision, regardless of the wrapper you engineer around the investment product. This is particularly true in places with a long history of hedge fund investing.
DE, Société Générale: That’s right. You can’t simply create a structured product and not care about the underlying and how it works. There is a convergence between structured products and asset management, which is what we call Structured Asset Management. We need specialists who understand the fund of funds’ concerns and the hedge fund liquidity concerns, not simply the pure quantitative issues of correlation between this and that strategy or the technicalities of portfolio construction. And so the new wave of structurers are less quantitative, more skilled in doing due diligence on funds and managers, and are more akin to fund managers and asset managers.
AP, CSFB: Another point on systemic risk: as a provider of structured products you think about that all the time. When the products are principal-protected and/or leveraged on multi-manager multi-strategy underlying risk, the systemic risk runs across all managers, all strategies and is mitigated by diversification across managers and strategies. In a world where people are taking more single-manager risk, more small baskets of managers, more single-strategy risks, there I think you’re taking a quantum leap in the systemic risk and you need to be much more careful on how you structure these transactions.
ES, Bank Julius Baer: For me one of the most interesting things about the newer structures is that they can, in some cases, change the fundamental risk profile of the underlying. For example, where hedge funds are used to manage volatility and the risk associated with equity markets, the creation of listed, exchange-traded products can undermine that.
Take the Dexion Equity Absolute fund that has gone to an 8% premium straight away: immediately you’ve got an element of risk that is not akin to the asset class, if we want to call it that, but what do you do? You want to hold it because there’s a valid reason why you’ve selected that component to go onto your portfolio, but all of a sudden you’ve got this return component over which you’ve no control, because of course the moment the equity market sells off then that premium is likely to narrow. I think that is an important issue in some structured products.
TB, UBS: I think that’s a very important point, but I think there are similar products which have mechanisms embedded in them that enable trading at net asset value at pre-set points.
I think the key thing about leveraging though is what it is that you are leveraging. There’s a hidden risk in leveraging strategies that exhibit very low volatility by three or four times because these are the strategies that are most susceptible to the infamous fat tails. I would rather see a moderately volatile but well-diversified fund of funds levered twice, than a very low volatility fund of funds levered four times.
I also think the separation of the leverage function from the way the money is managed presents some dangers because the leverage is no longer being determined by the portfolio manager who has the overall picture of the underlying risk.
RM, Alternative Investments: We only have to look at what happened in 1998 and 1994: you realise that you can build a very conservative portfolio, but when you have a market crisis or dislocation, correlations tend to spike and your supposedly low volatility portfolio experiences a significant drawdown. I am worried when there is such enthusiasm for leveraged portfolios when rates are as low as they can be and the risk is very much on the upside as we saw in 1998.
Also the negative impact of leverage can hurt you in two ways during a crisis: your own portfolio leverage, as well as the fact that the low volatility portfolios are very often the most levered strategies.
DE, Société Générale: But we see more and more investors or managers fixing their borrowing cost, using long-dated swaps.
RM, Alternative Investments: Yes, but what is the percentage of investors compared with those who don’t?
DE, Société Générale: It’s still small, but it is the largest investors, so in terms of assets it is getting significant.
FL, Aima: Are these types of products particularly applicable to certain type of investors? For example, if we look at European pension funds, they don’t seem to have opted for structured products in allocation to the sector?
BB, Deutsche Bank: I think the process goes like this: an institution decides to be in alternative assets; it allocates via a consultant or through a hedge fund of funds; then only later with more sophistication does the institution feel confident to move into structured products – by which I mean leveraged products. For guaranteed products obviously it’s the reverse.
DE, Société Générale: Yes. A lot of institutions in Europe and in the US are using guaranteed products as an ALM tool. The double-A guarantee creates an asset that fits easily into their existing portfolio and lets them fill gaps in their liability streams.
After they have been buying product for say, five or six years, then they move into leveraged product and want two or even three times the performance of the diversified fund of funds. Why? Because those institutions can be working with up to four or five different funds of funds, and they think that leverage is a better way to enhance performance rather than selecting another new fund of funds manager.
AP, CSFB: There’s one area we haven’t discussed where there has been a proliferation of activity and that’s investable hedge fund indices. I’ve been very surprised at how these have taken off, but it’s because there is a group of investors, institutional, high net worth and retail, who do still view this as an asset class and so find a rules-based index a very comfortable way of getting exposure to it.
OK, Permal Investment Management: Also, the reason it’s good to have this batch of investable indices is that it corrects the problem of historical hedge fund indexing, which was completely flawed: many funds were not investable; there was reporting bias; there was categorization bias and there was the issue of how surviving funds created bias.
It’s early days but I think it’s useful to have these alternative benchmarks.
RM, Alternative Investments: But so far I haven’t seen anything which is truly acceptable. If you look at most of these indices and their constituents, you have – what – often no more than 10 names? Is that representative of any investment style? Probably not. And then you’ve got all the biases that you’ve mentioned. So I am anxious to find a proper index or indices to measure our performance against. And you maybe have a view…
DE, Société Générale: Of course, my firm’s!
RM, Alternative Investments: At least the SocGen indices have multiple constituents.
DE, Société Générale: It depends what you expect from the index. It’s very difficult to have an index that is entirely representative of the industry and all the strategies, and that at the same time is investable and liquid. But it’s not impossible to get close to this goal, and I will have to talk about my own shop for a minute.
The way MSCI worked with Lyxor Asset Management was to have as many strategies as possible and as many managers as possible. So in the index, if I recollect, we have 88 managers now in the index. Obviously there is still bias. Why? Because this index has weekly liquidity so you cannot accept all the strategies and you cannot give a heavy weighting to the most illiquid strategies. What you expect from this index is broad exposure to the industry and a very liquid instrument. That’s it.
What is interesting is who uses the index. It was launched in August of last year and now has over $2 billion under management, but we were surprised to see that it appeals to a very broad range of investors – not only retail investors or high net worth individuals but also institutions, funds of funds themselves and other professional asset managers.
AP, CSFB: One of the things that we did in the Tremont index – we had 60 names – was to try to create a rules-based index that may in the future lead to a two-way market. It’s not there yet but we’re looking for people who want to short the index and we encourage the development of a two-way market in it.
RM, Alternative: Investments And that’s really one of the key goals of this industry: to develop a liquid market on both sides and on specific sector indices so that portfolio managers and investors will have the tools to be more efficient.
AP, CSFB: On the structured side our goal is ultimately risk transfer. We want to develop a two-way market, not only in the underlying hedge fund risk, but a two-way market in the option risk as well. So a lot of the stuff that we do is geared towards ultimately putting ourselves in a position where we create an efficient risk transfer market around hedge fund risk, around hedge fund volatility risk as well.
DE, Société Générale: It’s going to take time but I think we have to remember where equity markets were the middle of the 80s. Long-term volatility in those markets was very hard to buy or to sell – there was no market. Today, if you want to buy or sell a five-year option on a liquid equity index, it’s easy.
AP, CSFB: What is your timeframe?
DE, Société Générale: I think in four to five years we should have a market. Already today we see investors and market participants interested in buying the kinds of risks that investment banks used to keep for themselves. So you can buy synthetic CFOs [collateralized fund obligations] with an equity tranche and a mezzanine tranche that pays a very high coupon as long as draw-downs in the underlying funds do not exceed pre-set levels.
AP, CSFB: We are in the early stages of a risk transfer market in which the buyers and sellers of risk are not the same. The buyers of risk are the investors, the sellers of risk are predominately the institutional market and both sets have very different valuations for that risk. That is typical of the early days of risk transfer, and what will happen later is that the same participants will buy and sell risk in the future.
FL, Aima: On the subject of how the business is evolving, let’s talk a minute about the latest trends, with situations like Blue Crest and the valuation of a hedge fund business; let’s maybe touch on the RAB Capital example and whether a listing on AIM is the future for the larger groups?
BB, Deutsche Bank: In terms of the institutionalization of the top managers, the answer is yes: it’s the trend in terms of the way they manage their business in terms of operational infrastructure, risk infrastructure and investment management sophistication, so it seems logical that the institutionalization would migrate from their asset side to their liability side. That is ultimately what this is: they’re structuring and stabilizing their liability side.
It’s also a recent development that a hedge fund manager can convince equity investors that there’s multiple attached to the performance. As recently as 10 years ago it was impossible for even some of the most famous managers around to sell publicly. Certainly many of them made private sales of portions of their management company to various institutions, but a public sale was beyond the imagination of the public market.
TB, UBS: It’s interesting. A listing gives a
hedge fund firm a currency, the question is what are they going to do with that currency and how are they going to evolve with it?
AP, CSFB: Yes, the question is would it lead to consolidation in the industry that creates bigger and bigger institutions?
OK, Permal Investment Management: One thing I’d say about industry developments is that the likely outcome of the retail environments that are developing for hedge funds is that you may have a two- tier structure of the industry, where some will reshape themselves to compete in the retail market and offer their products and services there, and others will just steer clear of it and stay with their high end private clients, institutional clients, offshore clients. That will be interesting to watch at the same time as monitoring who performs and who doesn’t. Then we will know better whether you really are giving up something by being in a retail regulated structure.
TB, UBS: I think the key point is that the industry is still evolving really quickly. One aspect of course is the public listing of hedge funds we’ve been talking about. You may recall the paper by Byron Wien of Morgan Stanley in 2002 entitled, The Inherent Instability of Hedge Funds. In it he cites how when hedge funds tend to reach a certain size, they become unstable, for reasons such as portfolio managers defecting, an inability to keep putting more and more capital at risk, or simply the inability to keep performing.
The question is whether a listing and the effective institutionalization of hedge funds will be able to solve some of these issues. The key issue though is really the ability to retain outstanding talent.
BB, Deutsche Bank: If a manager believes there’s a diminishing marginal return with increased asset size within the strategy, then there is an algebraic formula that tells you the point at which the loss of return on your own capital exceeds the benefit of the fees generated on the external capital.
This is the calculation in fund manager’s minds as they begin returning capital and try to find their efficient frontier.
DE, Société Générale: I think the question is not “is the listing important or not?” What the listing says is that the industry is getting more professional, so, yes, those groups are going to get bigger and bigger.
The hedge fund business is about entrepreneurs: you are an entrepreneur; you have an idea; you set up your shop and you perform, and that’s it. But like most other businesses that start that way, they develop into organizations of 250 people, managed like any other type of business that wants to achieve the most efficient use of and access to capital. I’m not sure if it’s bad or good for the industry, but it is how businesses develop. Listing is just a part of this natural process of evolution.
FL, Aima: Well unless anyone has any further comments, I think that’s a good place to stop. Thank you all very much indeed.
