Monday, 30 November 2009

Risk Management in Hedge Funds –The Role of the Risk Manager

The extract below is taken from an article by Michael Langton, Head of Sales at Quality Risk Management & Operations (QRMO) Limited, that makes some interesting points. It was first published in IPAsia in January 2009. For the full article go to IP Asia or EurekaHedge. Only one sentence has been edited from the extract. The article first looks at risk management in financial institutions before turning to hedge funds specifically. The extract begins at the joint of the two parts.

What's wrong with Risk Management?
…Continuing with this example, risk management simply becomes a regulatory-required function to senior management that should only be put in place to appease the regulators, but one that under the surface of it has no real independent authority to balance the risk/return profile for the organization. Furthermore, the far more insidious fact of the matter is that investors will think they are investing in a prudent or well-structured institution and their capital is protected by these highly paid professionals.
Hedge funds are unregulated financial pools of money provided by qualified professional investors. The rationale for the existence of this industry is that traders can utilize their special skill sets to generate absolute uncorrelated returns for its investors. However, as with financial institutions, the compensation scheme is still asymmetrical in this industry and could arguably be even worse. This is because the hedge fund manager has the discretionary right to decide whether the fund needs to have a risk management infrastructure in place. It cannot be denied that there are some well-disciplined hedge fund managers that attempt to incorporate best practice risk management and operational infrastructures through the active use of and stringent adherence to a well thought out rules-based structure. However, they tend to be exceptional cases in the hedge fund industry as a good portion of them are purely return focused instead of risk-adjusted return focused.
Some fund managers consider themselves to also be the “risk managers”. Surely, their role as a trader is the first-line risk manager as they can actively manage their portfolio and adjust the risk-return profile dynamically. However, it should be recognized that they still need to have a risk manager in place as an independent verifier that the fund manager is adhering to the risk guidelines and rules put in place. The role of an independent risk manager is not merely to provide risk measurement and reporting but to also setup the necessary risk and valuation policies & procedures and risk limit structures and to monitor the market condition changes and related market exposures of the fund.
The most important role is to execute all risk policies & procedures as stated in the offering memorandum and additional guidelines provided to the investors. Unfortunately, risk policies & procedures execution is usually ignored and not enforced. In fact, some hedge funds can have very presentable and detailed risk policies and procedures, but they are simply for showing the investor how they perform their “prudent” risk management functions. They rarely delegate the authority to the risk manager to execute actions like stop loss or position reduction if limits are breached, for example. If a fund has a risk manager but the de facto person in charge for actions taken on limit breaches is still controlled by the fund manager, the independent risk management function should be called into question. There is a lot of talk about the need for better risk management, particularly given the current state of affairs in the global world markets. However, the focus should not be on better risk measurement, although this is still important. Instead, the real focus should be on corporate governance in ensuring that a proper risk management structure is in place and that it is independent, continuously adhered to and fully transparent to the investor. In essence, corporate governance will always be the key to good risk management. As such, for the future of risk management to be successful, its function has to be directly reportable to investors instead of internal management. Such a structure should carry out these two key functions:
· Greater transparency on what the institutions/funds are investing in (esp. on derivatives) and the accurate and timely reporting of their true risk-return profiles; and
· Risk management function must be truly independent from the profit making function, so investors can truly enjoy absolute upside return from the profit maker but still have downside protection from the risk manager
This structure will make the profit maker consider the risk elements of his strategy more carefully because they will know that the risk manager has the authority to enact his duties as per the agreed risk policies and procedures. Ultimately, risk management should no longer be viewed as a “regulatory-required” function but as a “value-added” function in the investment decision-making process. The “value-added” does not derive from making money, but rather from capital preservation, particularly in down markets.
Experience, discipline, communication and common sense are always the essential elements of a good risk manager. Some market participants misunderstand that having expert quantitative staff and a sophisticated risk system is sufficient. This misperception stems from a false sense of comfort that can come from the risk managers’ utilization of a lot of different mathematical models (e.g. VaR, Monte Carlo, auto-regression, scenario analysis, etc.) through the use of expensive state-of-the-art technology to assist the risk manager’s decision process. However, these quantitative elements and technologies are not the only factors needed to determine whether the organization has a robust and proper risk function. More importantly, an experienced risk manager needs to effectively communicate with the profit makers and understand the risk and return of each product/portfolio while also demonstrating these risks to senior management and investors.
In summary, inevitably regulation will always be tightened post-crisis, which will, in turn, prompt the need for more robust risk management to avoid crises from happening again. However, this time, regulators and investors should consider demanding changes at the highest levels of the corporate governance structure. These changes will need to grant the risk manager a more independent role which can directly report to investors (especially within the hedge fund industry), so that risk management can play a more pro-active role. It goes without saying high quality risk managers that have a better understanding of risk will also be a key to successful risk management. Importantly, sophisticated risk systems and quantitative models are not the only components of a solid risk function. In some cases, good old common sense will be a better suited method to justify particular actions to a given situation. (end of extract)

From Simon Kerr:
I have enjoyed a privileged position over my 11 years in the hedge fund industry. From 1996 when I attended my first hedge fund conference in London (there were 5 paying attendees, way out-numbered by speakers), I have met many first-rate hedge fund managers. I now apply the insights they have given me in my consulting work, and in my own investments. One conclusion I have reached from meeting first-tier managers is that the very best hedge fund managers have a keen appreciated of risk management. An understanding of what risks they are currently running and how those risks might change, subject to market dynamics, is a core competency for them. The kind of preparation for the trading day undertaken by the likes of Paul Tudor Jones and Steve Cohen is one of the reasons for their successes, and both include elements of risk assessment as part of their preparation for battle. They get/produce relevant risk information for their style, they think through various scenarios that can happen to their exposures, and they plan responses. A good local example is Lee Robinson of Trafalgar Asset Managers in London.
Robinson’s view is that market crises in reality happen with a greater frequency than generally perceived. “Markets have had serious moves almost every year this Millennium,” he has said. As a consequence Robinson has disclosed that the bulk of their work on a trade at Trafalgar is preparation. “We are prepared for the worst,” was how he summed up the rehearsal of various possibilities (mark-to-market difficulties, drawdowns, shifts in volatility, and redemptions) that might be experienced en route to the planned exit points. He said that the aim is not just to avoid losing money, but to avoid the forced liquidation of positions. He has succeeded in that aim: the graphic below reflects that his event-driven Trafalgar Catalyst Fund made absolute returns of 4.83% last year. Since inception the Trafalgar Catalyst Fund has compounded at 9.7% (in the USD Class) versus 2.2% for the HFN event Driven Index over the same period.
NAV of the Trafalgar Catalyst Fund (USD)since inception
Lee Robinson has made a conference speech titled “Lessons from the Crisis”. He made it in November of 2007 (not 2008 or 2009!), so he was ready for the unfolding crisis from having seen warning signs in the previous few months of 2007. In his presentation he talked about portfolio management. He stated that it was easy to have investment ideas, but difficult to mesh together those ideas into a coherent portfolio, and even harder to make that portfolio robust to varying market conditions. He cautioned that investors in hedge funds should look closely at funds that exhibited high weekly and monthly correlations, and to beware of funds that had high concentrations of risk. Robinson continued that all portfolios are essentially short liquidity and at risk to mark-to-market movements, but that all great portfolio managers have tools to combat these problems. Robinson suggested that carrying long put option positions below spot which defines the downside more clearly, and being short interest rates and short credit will all help, or if you like, are examples of such tools. Lee Robinson concluded that “The best managers are not the ones with defined upside and a wide range of possible downside outcomes. They are the ones with defined downside and a wide range of upside.”
Whilst the tools Lee Robinson suggested may be specific to his event-driven strategy, a more widely applicable point can be made: portfolio construction has to take account of the possible outcomes for the asset class/specific securities including downside and liquidity risks, and particularly tail-risk. The best hedge fund managers manage whole portfolios not just select securities or investment themes they like (longs) and dislike (shorts).
My second major point is that risk managers work best when they work with and alongside portfolio managers. This applies whether in a long-only firm, a hedge fund management company or some combination. Several good examples come to mind. At Augustus Asset Management, the fixed income specialist part owned by GAM, Risk Manager Amy Kam sits in with the portfolio managers and is part of general discussion on trading strategies and the dialogue on portfolio level risk and rates. Augustus uses stress-testing, simulations (Monte Carlo), and sensitivity analysis in the arsenal of risk assessment tools. The risk control framework goes beyond the managers’ spreadsheets and is externally supported (by Riskmetrics) and working with GAM’s wider risk analysis capabilities.
The physical location of the risk manager in the office suite is indicative of their hierarchical position in the firm and their level of significance to the portfolio managers. It is one reason why, even on a brief visit to see a manager, a look at the trading room is always useful. An example of this is Charlemagne Capital in St.James’s London. The office space is a little tight so it would be all too easy to place the risk manager in a room adjacent to the analysts and PMs. But at Charlemagne the risk manager is too integral to the investment process for him to be squeezed away from the hub of investment activity. The risk manager at Charlemagne Capital works with the portfolio managers day to day on their portfolio construction challenges and not just reporting to investment team heads Julian Mayo and Gabor Sityani once a week.
The final point is that risk management is most effective when it is an element of the investment culture rather than a segregated function. Too often the risk manager can be seen as part of the oversight of fund management activity rather a core element within it. The risk manager as part of compliance or as a policeman looking for infringements of policy may be useful for marketing purposes but is unlikely to play well with the star portfolio manager. There is a chance that the risk manager will be seen as having no relevance to the men and women running the money. This quasi-regulatory attitude and structure is very limiting and indeed isolating for the risk manager. The senior management of the asset management businesses whether hedge or long-only can do something about these potential difficulties by recruiting a risk manager with the right attributes – they should be bright, open, engaged with markets, experienced, have good judgement, and be both quantitatively capable and have good people skills.
This is a long and demanding list of characteristics, and perhaps its length makes clear how difficult it is to find the right person for these roles. The attributes are also those of the best hedge fund managers – which is why the hedge fund managers are often also their own risk managers!

Wednesday, 25 November 2009

The Limits to Fundamental Conviction – Clarium Capital

In August 2007, perfectly catching the first public intimations of a financial downwave global macro manager Clarium Capital, then of San Francisco, dispatched a manager letter that took a negative view on economic growth, real estate and the stock market. In the letter they wrote ""We have begun a post-Long Boom phase that can be called the Long Goodbye. Returns during the Long Goodbye will be lower -- perhaps half as much -- than those of the Long Boom."

The firm argued that the developed world has entered a period of lower returns in which interest rates and economic volatility would increase while growth in corporate profits and global expansion decline. To adjust to this new reality, the firm explained that people must work more, consume less and compensate for lower returns by using more leverage -- borrowing more, that is. The prudent response would be to work longer and cut consumption, but up to that point the reaction had been just to borrow more, Clarium said.

Chillingly, Clarium predicted "that higher leverage has made markets much more vulnerable to outside shocks that will force "painful" de-leveraging and a reduction in liquidity." Clarium built these economic scenarios and market forecasts into portfolios through several investment themes. One was being short the US Dollar, and another was shorting shares of leveraged companies. In the second half of 2007 and early 2008 Clarium made stand-out returns on these themes (see table).

2007 Returns

2008 Returns

Clarium's excellent research had also put them into the camp that believed in the peak oil concept, making oil prices more sensitive to small changes in the demand/supply balance, and giving prices an upward bias over the long term. As it turned out, Clarium's investors didn't have to wait for the long term to arrive and for a payout on the long energy positions Clarium ran – in the first half of 2008 the oil price accelerated to the upside and Clarium's returns reflected big long exposure to energy, gaining 11.2% in May 2008 and 16.0% in June.So in the middle of last year Clarium Capital's principal, Peter Thiel, was a "Master of the Universe". In the first six months of 2008 his Fund was up 57.9 percent. Significant inflows followed the turn of the year returns, and by the end of July 2008 Clarium Capital Management had assets under management of $7.3bn.

Clarium's Peter Thiel, source:Bloomberg
Clarium stayed short of the US Dollar and long energy as the start of the second half of last year, so in July and August gave back some of the gains of the first half of 2008. Bets against the world's reserve currency, the US Dollar, in a time of crisis would not have helped returns at the time of the collapse of Lehmans and the follow on problems at AIG and the UK banks (October/November last year). So after a bang-out first half, Clarium ended 2008 having made a small loss of 4.5%. Better than most hedge funds across all strategies, but the Clarium returns in the second half of 2008 were worse than the peer group global macro managers, and across the whole year the small loss was delivered to investors with very high volatility. Many macro managers run steepener trades as portfolio insurance for a liquidity crisis, so many macro managers were positive in each month of the final quarter of 2008. Clarium didn't carry that insurance and had losses in two out of three months. Like the whole industry Clarium Capital suffered major redemptions in 2008, but the scale of some of Clarium's monthly losses hastened investors to the exit. AUM were $2.5bn at the end of 2008.

2008 Returns

Peter Thiel has been quoted as saying recently that "There was a degree to which the financial economy has been extremely decoupled from the real economy." He has noted that he didn't expect the S&P 500 to rally 62 percent, its steepest advance since the Great Depression, at the same time that the proportion of Americas without a job rose to a 26-year high. The Clarium fundamental call has been that the economic recovery would be at best constrained."A real, sustainable recovery is not possible without productivity growth," said Clarium's Chief Economist Kevin Harrington. "The recovery is not real," he says. "Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again -- that's long been my thesis and it still is." He continued, "The government has helped stabilize the banking system, but I'm not sure we have a path toward sustainable growth, partly because consumers are dealing with debt and other issues, even as an energy crisis looms. It always feels unpatriotic to be negative. But too few people are focused on the real problems."

Thiel himself is of the same mindset: "I don't think that a recovery is impossible. I do think its quite hard to get to a situation where you have a lot of growth in the economy without running into basic constraint problems.

 "The key thing in the US is going to be doing more with less. If you try to do the recovery by just doing more of the same and if the recovery is going to consist of going back -- to the housing bubble, going back to leveraged finance, lending money again like crazy, going back to 2005 -- it just seems to me like you're setting yourself up for a real problem. I think you would run right back into four dollar a gallon gas prices and it would sort of correct itself [back into recession].

"Longer term I'm hopeful. I'm not wildly optimistic…But I don't think it gets driven by the financial system or even has that much to do with macroeconomic policy. I think it basically has to do with getting innovation working again. I think that's a very long term trajectory. I'm pessimistic in the sense that I don't think people are focusing on that enough."

Implementing these views Clarium was long the Yen and Dollar in the first quarter of 2009. . The Dollar positioning in the first half reflected an implicitly deflationary view, and Clarium has been long of high-quality bonds based on the view that fear will prevail in markets in 2009. That fear in terms of stock markets peaked in March, and since then stock markets have rallied hard. It appeared to the investment professionals at Clarium that valuations on equity markets quickly became rich, and they have shorted stocks into the middle of the year. And paid for it:

2009 Returns

Global macro managers are paid to take a view on how the economic environment is going to impact market prices. If markets reflect the fair values of stocks, bonds and the parities of fx rates global macro managers have no trades to put on. They trade on where prices are going, given their view on the dynamics of economic growth, final demand, inflation and job growth, in the context of markets subject to the emotions as well as the rational thinking of investors.Modern form macro funds aim to have five or six themes running in their portfolios. The themes are only distinct to the extent that they are uncorrelated. So if two trades are long yen call options as a probabilistic bet that the carry trade unwinds in emergencies, plus a yield curve steepening trade then there are two trades that will work for the same scenario, and they will be tightly correlated when you expect them to work. Long gold and long index-linked bond trades can be thought of the same way. Late last year was a period when correlations between positions were either +1 or -1. So it was very difficult to construct trades with a macro take on markets that were not very correlated (positively or negatively).
Many managers in macro use VaR type measurements of portfolio risk. This methodology is flawed but still useful for macro managers because it allows risk assumption across different asset classes to be measured on a common basis. Although macro managers are not as micro-controlled as equity hedge managers in risk-assumption boundaries they can and do vary risk assumption according to shifts in markets, including regime change, which is what we saw in the Autumn. So macro managers have a free choice about maintaining, increasing or cutting their risk assumption as market values move, just like hedge fund managers in other styles.
One of the tenets of running money, particularly for other people, is that you earn the right to take risk. On an individual level Peter Thiel did that by co-founding PayPal, and so started Clarium with capital which was merited. The annual return series for Clarium given below shows the classic global macro pay-off profile: the portfolio is run as a series of bets some of which become highly profitable. In concept a global macro fund runs a series of themes are run to give a chance to smooth out returns, and losses are limited by three things: trades which have natural downside protection (like the bond floor of convertibles, or a hard asset value), strategies are put on with delineated stop-losses from the outset, and options are used to implement the views. So the return series should look like a strip of option positions – occasional big pay offs interspersed with dull returns (small losses and small profits).

Annual Returns of Clarium LP

In the case of Clarium several of the tenets of running money, and running money in the modern global macro format specifically have been broken. These are matching stop-losses with the risk/return profile, diversification of theme, and arguing with the market without a suitable limit.There have been 14 double-digit monthly returns in the Clarium performance history, both gains and losses. That scale of monthly return is only feasible with the use of leverage. The use of leverage carries the inference of high conviction and/or investing capital in low volatility assets. Soros used leverage (re-hypothecation) on his bond positions in his heyday, and traded forward currencies in large size using the implicit leverage of forwards with no margin in low volatility instruments. So leverage per se is not a bad thing, and in normal markets is necessary to potentially generate 20% absolute returns from low volatility instruments.

Soros used to load up on a position when it started to turn his way - the foot-to-the-floor version of risk assumption. That is the investment hypothesis had been tested in the market and shown to be positive, so reinforce the winners. Contrarily, the markets are very good at teaching lessons in humility – so if a position started to ship losses Soros was all over it , and mentally able to cut it and re-visit at a more opportune time. So capital was dynamically applied at Soros Fund Management with the feedback loop of the P&L delivered by the positions in the market.

The other feedback loop that managers use is the fundamentals – have they mapped out as forecast? Is the road-map of the progress of the macro factor turning out as expected at this point? Some, indeed many, managers will argue with markets (running a negative P&L) on the basis that their fundamental view is being borne out in the real world away from traded markets. So if trade deficits are the key factor in monitoring fx rates at the time, and the trade balance is progressing as expected then managers give themselves the right to argue with the markets for the time until their conception is generally recognised in FX cross-rates. Of course there may be other factors influencing the fx rate, and the rate of progress may not be as laid out in the road-map. There is room for judgement, but not for behavioural biases counter to the facts.

In the case of Clarium the losses of August and October last year are prima face evidence that the tenets of macro management were not being followed. If there were effective stop losses at the portfolio level or by theme and the portfolio themes were indeed non-correlated then a single month's loss should not reach 13 or 18%.

As stated, last Autumn was exceptional in the shift on volatility and correlation. However part of what investors pay for in the modern hedge fund world is superior risk management. Exposures should be cut at a hedge fund at the portfolio level to ensure that the target maximum monthly loss should not be breached. Clariums' track record from 2002 to 2007 showed 3 monthly losses of 11% or just over 11%. Given the size and number of positive months that maximum monthly loss was (just) tolerable. But a loss of 18% was not and is not. Exposures should have been cut intra-month so that the target maximum loss was not exceeded. As much as anything else that was a logical reason for investors to withdraw their capital, as they did towards the end of last year at Clarium.

This year is different again. It is clear that the Clarium view on the economy is the same now as it was at the beginning of the year. That is fine – it has been a disappointing economic recovery in some senses, and so in macro-economic terms Clarium have been broadly correct this year, and may be borne out on their forecasts beyond this year. How those views have worked out in traded markets has been less successful – Clarium were down 15.8% by the end of September.

It looks like September 2009 has been a signal month for Clarium Capital Management. The Clarium Fund lost 8% in the first 14 trading days of the month. Between between Sept. 11 and Sept. 19 Clarium cut leverage from 4.2 times down to 1.4 times equity, and closed the month with a loss of 8.1%.

I would contend that the commercial position of Clarium Capital Management LLC was different this year than during the rest of Clarium's history. The large losses of August and October last year, the withdrawal of investor's capital last year, the increase in frequency of losing months, and the fact that the Fund is well below its high water mark (so vulnerable to staff losses) all shout to me that the remaining capital ($1.6bn at the end of September 2009) should be run more conservatively than hithertofor.

I do not think that managers in the position that Clarium was in this year should argue with the market to the extent in terms of scale and time that Clarium did. Being right on the economy only mitigates the position to the extent that positions in markets make money. There are natural limits to risk assumption in global macro, and to an extent Clarium lost some of its degrees of freedom in that regard from the outcomes last year. This year the natural limits to fundamental conviction for the firm should have kicked in a lot sooner than September.

The above was put together using material from various sources. I acknowledge the use of quotations and data from Bloomberg and The New York Post. The use of appropriate feedback loops and money management are core concepts used by Enhance Consulting, Simon Kerr's consultancy.
useful link: manager letter (April 2009)

Tuesday, 24 November 2009

Apologies to Polar Capital

In a recent post ("Lack of Transparency Traduced") I mentioned that on-shore products would do well to follow the example of hedge funds in regard to communications with investors. UCITS III funds are the new vehicles for fully regulated absolute return funds from asset management companies, and as an example of incomplete communication I mentioned an absolute return product from Polar Capital, having seen a monthly newsletter.

I had not appreciated that I was in receipt of an edited version of more full monthly letter. So my apologies to the managers of the Fund and Polar Capital's marketers that their efforts were mis-represented. It turns out that the same sort of information is provided by the firm for its hedge funds and its absolute return range.

I hope the information provision by Polar sets a good example for those that launch absolute return UCITS products in the future, following the high standard set in the hedge fund industry.

Non-Confirmations Multiply according to Prechter

Although I am not an Elliott Wave technician, they do have market influence. Hence awareness of leading practitioners is a useful background input. Robert Prechter is such a practictioner. Bob Prechter's "Elliott Wave Theorist" newsletter published the 23rd November notes that the DJIA has achieved a 50% retracement of the fall from the 2007 high to the 2009 low, and has done so in 50% of the time it took to fall.

The following is taken from the same publication:

"Non-confirmations continue to multiply, as no other significant market index – among the S&P, NASDAQ, Transports, Utilities and the broader Value Line indices – joined the Dow in making a new intraday high today.

This morning's high occurred 39 minutes into the session, immediately after an upside gap in the DJIA during the session (his italics), an extremely rare event…I am betting that it was an exhaustion gap, not a continuation (wave 3 of 3) gap.

After 8 months of rally and a 52% retracement, I believe I have seen enough to recommend that traders move to 200% short. Those who were "maximum leveraged" for the 2007-2009 decline and reinstated half their positions on the recommendation in the August 5th issue may return to their full former holdings now."

Prechter's services can be found at

The NYSE cumulative advance/decline indicator is a measure of market breadth. It is giving a non-confirmation at the moment - the NYSE Composite hit a minor new high a week ago, but the advance/decline did not then or since. Non-confirmations are useful to give confidence for high conviction calls on the market. The evidence is building for a high confidence bear entry point.

Friday, 20 November 2009

Significance of Hedge Funds to Gartmore

Gartmore is to obtain a Listing on the Stock Exchange. The press release for the announcement states that as at 30 September 2009, Gartmore and its subsidiaries had £21.8 billion of assets under management ("AuM”) including a range of 14 equity long-short funds that make up £3.8 billion ($6.1 billion) or 17% of AuM. Since July 2009, Gartmore has had over $1 billion of net inflows into its alternative funds, but it received £924 million ($1.54bn) of net inflows in the third quarter of 2009 across the whole Group. So equity hedge funds contributed around two thirds of the net inflows in the third quarter this year.

In addition 87% of the hedge funds were above their high-water mark as at 30 September 2009, and these funds were up by 17.3% for the 9 months ended 30 September 2009. So it looks like the profit growth of the business will be a function of the returns of the hedge fund unit next year. That is how important hedge funds can be in the asset management business.

Wider implications of a Gartmore flotation were covered in the podcast on this blog on hedge fund M&A:

Monday, 16 November 2009

Lack of Transparency Traduced

One of the most commonly repeated fallacies about the hedge fund business is that it lacks transparency. I think the opposite: in many ways hedge funds provide much better information flows than long-only managers. Hedge funds cannot be easily sold, but are more often bought, and may only be bought by experienced and provenly-monied investors. So if someone is a qualified investor they can be in receipt of a plethora of information on a potential investment in a hedge fund.

The information flow is different at different stages, and is provided in several ways. In order to subscribe to a hedge fund investors are sent an offering memorandum or prospectus. They are usually sent a presentation document of some length, and most investors in hedge funds get to meet the manager of the Fund. He can answer their specific questions directly. When a potential investor decides that they are seriously interested in a hedge fund they will ask for a further set of information flows – portfolio snapshots and transaction lists to analyse, and the potential investor will ask for a completed due diligence questionnaire. The standardised due diligence questionnaires go into detail on the management company, business structure, ownership and resources of the investment advisor to the fund. The investment processes and risk management procedures are disclosed. The due diligence questionnaire can run to 40 pages once completed. Prior experiences and track records of the principals will be made available to a serious potential investor.

Once a potential investor subscribes and has capital in a hedge fund they receive other information to keep them abreast of developments in their fund. Typically hedge fund managers send out a monthly written communication (or "letter") to investors and potential investors. The letters - usually sent between 3 and 10 business days after month-end – contain a lot more analysis of activity and the portfolio than a long-only manager would provide. The letters from a hedge fund typically contain a breakdown of the portfolio by sector and geography and sometimes macro factor exposure. The largest sector and individual position exposures are disclosed. The use of cash and effect of current hedging is often given, and the liquidity of the portfolio is sometimes reflected in days-to-liquidate information. The portfolio risk is often described in exposure and VaR terms. Often the letters contain some P&L attribution and risk concentration information.

In addition to the letters, managers sometimes grant elective access to the portfolios they run via either the websites of their prime brokers and/or a third party risk measurement/attribution service like Measurerisk, or Riskmetrics. For investors that mimic a fund through a managed account, a further level of disclosure is available - the portfolio activity and exposures are then visible real-time. Portfolio managers of hedge funds now arrange conference calls for their investors, and podcasts and video links to keep their investors informed on a current basis and facilitate some interaction with the manager whilst not consuming too much of his or her time.

Contrast all the above with what an investor in an OEIC/UCITS receives for information flows – reports twice a year, months out of date, and with a low level of information and little analysis of either activity or the current investments/portfolio. The portfolio manager is extremely unlikely to be available to talk to a potential investor in an OEIC/UCITS, and the investor might find it difficult to get hold of a marketing person to quiz, nevermind the key decision-maker.

So qualified investors in hedge funds that display serious intention do not have issues of transparency with hedge funds. Only those who do not need access and legally cannot have access are excluded.

There are now dozens of funds that could be characterised as a half-way house between a hedge fund and a mutual fund or OEIC – absolute return funds. Major investment houses have started these funds to make available to retail investors some of the hedge fund investment strategies. The providers are hopeful they can offer products with the advantages of hedge funds in terms of scope of investment powers (wider than a long-only fund), but without some of the disadvantages of hedge funds (poorly regulated offshore domiciles, high fees and restrictive redemption terms).

I am disappointed that the onshore investment industry has not taken some lessons in communication from hedge funds: absolute return funds are producing manager letters, but they contain only pale shadows of the information shown in a hedge fund manager letter. Polar Capital is a quoted manager of long-only and hedge fund products, and has been running the UK Absolute Return Fund for 17 months. The monthly letter contains only monthly performance numbers and a graph of the same, plus six paragraphs of text – half looking backwards and half looking forwards. That I completely agree with the manager's outlook (given below) does not detract from the point that it exemplifies - investors in hedge funds get better transparency than investors in other forms of pooled investment.



We remain cautious over the near term outlook for global equity markets. The recent reporting season on the whole was better than expected, largely the result of both cost cutting and strong cash generation. Revenue growth remains subdued but largely stable. However, as we said last month, it’s better to travel than to arrive; the internal dynamics of the market are not encouraging and whilst sentiment indicators are far from extreme, we expect the market to drift lower over the coming weeks, which should provide a better entry point into stocks with less market risk attached. As we near the end of the year, who would have thought that global equity markets would have performed so strongly? Many investors who are sitting on decent profits, (and with November the last liquid month for trading) will want to avoid risking these profits and are likely to be nervous holders of risk assets going into year end. On balance, we therefore expect a period of heightened volatility with risks skewed to the downside. As they said in one of the Godfather movies, it’s time to ‘go to the mattresses’, meaning time for war. A battle between the bears and the bulls is likely to persist for a while, with plenty of ammunition for both sides of the argument.

The Fund is currently modestly net short on both a dollar and delta adjusted basis and is exhibiting an inverse correlation with the market. When we feel the risks to the downside have either materialised or passed, we will be quick to take up our exposure levels in order to capture the value we believe is inherent within our long book.

Philip Hardy, Polar Capital, 5th November 2009

Friday, 13 November 2009

Two-Way Battle Continues Between Buyers and Sellers

The Greenwich Alternative Investments Macro Sentiment Indicators are based on the outlook of hedge fund managers employing a macro view and who manage, in aggregate, in excess of $30 billion in assets. The purpose of the indicators is to reveal how these managers believe the S&P 500, the U.S. Dollar and the U.S. Treasury 10-year Note will perform over the current month. There is an interesting trend in the results over the last three monthly surveys.

Greenwich Alternative Investments Market Sentiment Indicators
for U.S. Equities (S&P 500)

The survey is released on the 2nd of the month and this month shows that those who use a macro view to run their hedge funds are in one camp or the other – nobody is neutral. The neutrals have tended to become more bullish, and a minority of those that were formerly neutral have become bearish.

There have been two distinct phases in the rally to date. The first phase (March to end May then a month of consolidation) had a much steeper ascent than the second phase (early July to mid October). These have been two phases of a liquidity-fuelled rally from a massively oversold bear market low. The later stages of phase two were accompanies by some recovery in the real economy - 3Q GDP was up after all. Classically the real economy will continue to draw money from financial assets – the liquidity push and then cushion will be defused over time.

The breadth and volume in equity markets reflect this gradual withdrawal of liquidity – there is less buying power evident now, and selling has more of an impact on prices. The declining momentum is picked up in the lower peaks of the (14-day) RSI on the top of the S&P chart below.

I am grateful to Bernie Schaeffer for pointing out that the 80-day moving average has been significant to this market this year. Having touched it in July the S&P 500 has flirted with it at the turn of this month. The upside this month to minor new highs has caught some market-watchers: chartist Greg Troccoli wrote this week “I didn’t see this type of strength coming. The bigger picture at this juncture is quite interesting. The resiliency of this market is admirable, however, as can be viewed in the chart the major portion of a possible head and shoulder top has already formed. The right shoulder is coming together at this time- only time will tell if in fact this topping formation will come to fruition. Note that the right shoulder is usually higher than the left- which is taking place now.”

A head and shoulders is a reversal pattern that takes place over a period measured in weeks or months. For my part I see a distribution taking place – less buying power accompanying the market going up this month – the volume has noticeably dropped as the markets climbed from the 80-day MAV. If a head and shoulders does emerge, many participants and commentators will be on it. The measured target for a H&S on the S&P is the 950 area – exactly where the first phase started to consolidate from in the first half of June, and a good support level.

Whilst we see which camp becomes dominant on a multi-month basis, the waning buying power at work suggests that the bears will soon dominate, but there is not a clear sign that the bulls are out of it yet. So we could see a minor new high on the S&P shortly. That would be an untrustworthy further rally given what has unfolded over the last month.

The distribution referred to in these posts could be a trading range market for a while. It doesn’t have to be a dramatic fall to the bear market lows. After this year’s gains a visit to 950 on the S&P would be neat technically. But the consolidation of the gains could be a longer lasting sideways band – say 150 points trading up and down on the S&P lasting 6 months. There is more than one way to consolidate a rise, even a major liquidity-fuelled one.

Wednesday, 11 November 2009

A HF Joke - Allocators of Capital and Marketers

A group of hedge fund allocators and feeder fund marketers are all travelling by train to Lausanne for the same conference. The allocators of capital make a big deal out of making sure they each have their tickets, but the marketers report that they just had one of their number buy a ticket, and the rest would do without, which the allocators of course thought was just braggadocio. Before long, the conductor comes down the aisle, collecting tickets, and all the marketers of feeder funds get up and crowd into the toilet. After the conductor collects all the rest of the passengers' tickets, he knocks on the WC door, demanding, "Ticket!" The marketers slip their one ticket out the door, which the conductor takes and stamps and hands back before going on his way.

One the return trip, the allocators of capital to hedge funds are all a-grin, and they proclaim that they've just got one ticket between the lot of them. But now the marketers say they haven't any tickets at all. The allocators mumble amongst themselves words to the effect of, "Marketers, what are they like!" Then the conductor starts down the aisle, and all of the allocators crowd into the toilet. And one of the feeder fund marketers goes the the WC door, knocks, and demands, "Ticket!"

Tuesday, 10 November 2009

Galleon Edge Illegal, But Information Flows to Hedge Funds Can Be Important

The information that hedge fund groups use is a topic that comes into and out of focus. Recently it has been in the spotlight because of the Galleon-related indictments, but it has been a live issue as far back as Ivan Boesky's advanced receipt of deal-flow information in the mid 1980's. Over the years the buy-side has decreased its reliance on traditional sell-side research, partly because of Regulation FD. Also the reliance has been downplayed to put marketing emphasis on the prowess of in-house efforts in research - it is widely marketed as a differentiating factor in asset management pitches. These concepts apply even more so to the hedge fund business.

To a great extent, and particularly in America, hedge fund managers are paid their large fees to be experts in a particular area. As America is home to so many hedge funds and has a deep and broad range of stocks and industries it is natural that there are hedge funds that specialise in particular fields such as healthcare and energy. Investors pay their managers to be the best informed participants in their sector.

This concept applied in different ways to two of the dominant firms of the early to mid 1990s. Michael Steinhardt in his pomp was well known to have the highest commission bill and commission rate on the Street. His thinking was that if he paid the highest rate he would be first call from an analyst or block trader. Given the turnover in his funds and assets under management it is easy to see how he became the biggest client of the brokerage community. And it worked – he was the first call for the sell-side. Steinhardt both traded and invested. So he liked to be in the flow of trading in a stock, and he knew where the axe was in any particular stock. There are many modern era equivalents – if you are a trader-style hedge fund manager you have to have a feel for the flows, and have finely-tuned antennae for the change of ownership in stocks and sectors. This is said to be how some hedge fund operations have grown within the context of institutional investment firms. The transaction flow information from the dealing desks (monitoring institutional and hedge fund flows) feeds the information requirements of the faster-moving hedge fund managers under the same roof.

Steinhardt was an investor as well as a trader. Although he was known for calling the turn in bonds in 1983, he was essentially an analytical investor rather than a macro manager. His background was as an equity analyst, but his trading around long term positions left the impression on the Street that he was what we would think of today as an SAC-style trader. He was not (only or just). Something similar has happened to the perception of what Julian Robertson's Tiger was about. Yes the firm engaged in macro trading, but the core activity was relative value investing within sectors (and in the mature period, markets). The ultimate arbiter was Robertson, but there were analysts dedicated to sectors. Analysts had to defend their views on the sector they covered, and the analysts were expected have profound knowledge of their sectors. In the later stages analysts ran portfolios in their sectors, and so gained the experience that would set them up to become the Tiger cubs that grew out of the firm. But the core competency was depth of knowledge of a sector.

Managers have to have an edge. It is requirement that they are able to answer well the standard question "what is it that makes you unique?" Further, the question had better be answered with reference to repeatable elements. The question becomes "what are you going to be able to continue doing that will give you a persistent edge in your trading/investing in future?" In this regard, it is much less satisfactory to investors to infer that the manager is going to do the same as other people running hedge funds, but do the same things better to deliver superior returns. If the manager happens to be better at using the same information flows as others – better at interpretation or quicker at understanding –that is not as sound a commercial response as declaring possession of an information edge, an unusual source of data. It could well be that money management is the key skill in driving the returns of hedge fund manager. Money management is the change of position size at the stock, sector and market levels. Indeed I have worked closely with a manager who had little edge in information flow, or even in understanding of companies through analysis, but had such good money management and risk understanding that he is an above-median hedge fund manager largely through that ability alone. But money management would not sell as well as a marketing point as an information edge. Rather, investors in hedge funds express strong biases towards managers with information or understanding edges in relation to company fundamentals.

Very often investors will state explicitly that they only invest in fundamentally driven hedge funds. A good example of the latter is the DB Equilibria Japan Fund run by James Pulsford at Deutsche Bank. Using the HOLT system, the approach of Pulsford's team rank return-potential based on RoE, cashflow and other fundamental metrics. Because they match long and short positions in pairs and stay market-neutral they can make good absolute returns using an investing time-frame (multi-month holding period). The DB Equilibria Japan Fund made money last year and this year for its investors. Somehow this sort of investment process is superior in the minds of investors to a manager that uses non-fundamental information to select stocks, or manage the position size.

In my mind the institutionalisation of the hedge fund industry is a factor in this behavioural bias towards fundamentally-driven strategies. They are much more easily explicable, even though there is increasing attention paid to behavioural aspects of finance and investing. And this bias to fundamental styles of investing reinforces the need to demonstrate an information edge. For a manager just using sell-side research it is difficult to claim that they have an edge. Interpretation is not sufficient. So other initiatives have to be taken to have an edge and demonstrate it to potential investors.

The first is the employment of analysts. As hedge fund groups have grown, like the rest of the buy-side they have added analysts. In truth, for investor perception, fundamental analysts have to be added to a small hedge fund operation before any other capability in the firm. Say you are going to add an analyst and you get a nod of the head at an investor meeting. Say you are going to add a marketer to a small hedge fund firm before adding an analyst and the manager would be thought the less of. Not that analysts at hedge fund groups don't add a lot of value in some cases - analysts at hedge funds can be award-winning in their understanding of companies they follow – like Charles Evans Lombe at Egerton Capital in capital goods companies, or Robert Donald at GLG building materials, who both gained plaudits in the Extel survey this year.

The second initiative that hedge fund groups have taken that help them demonstrate an information edge is in procuring (primary) research. Leading hedge funds now deploy a wide range of industry experts on an out-sourced basis via consultancies and specialist research houses. It is not uncommon for large US hedge fund groups to retain political consultancies in Washington to get a handle on the probabilities of regulatory change in various industries. Healthcare specialist funds might tap into firms that understand the workings of the FDA, or can interpret clinical trial data to commercial effect.

Leading hedge fund groups have enough capacity in research spending to commission their own research – footfall at malls or in particular chains of shops, interviews on the street with shoppers on particular brands, counting of cars at import terminals, or monitoring iron-ore ship-loads at Australian ports. Sometimes managers at different hedge fund management groups get together to fund such primary research. Student interns are sometimes brought in to carry out bespoke research projects.

A third initiative taken by hedge funds to obtain a demonstrable information edge is the use of expert network providers like Vista, Coleman, and Guidepoint Global. There were seven such firms just over ten years ago, and there are at least 24 operating today. The largest is Gerson Lehrman which is the only expert network company with a global network. It is instructive that Gerson Lehrman was founded (in 1998) by Mark Gerson and Thomas Lehrman who had spent the prior two years at hedge fund Tiger Management.

Of course, many hedge fund managers talk to their companies directly to produce an understanding of the companies in their universe, which can be an edge. Meetings with senior executives can be limited as sources of information, given what the executives feel able to disclose in Western countries. A common tactic to get some useful information from a company meeting is to talk and ask about competitors. It is often seen that investors pair up in company meetings – one staffer to ask the prepared questions and one to observe the body language and reactions of the executives. One manager I know seeks better operational level information by using extensive contacts at the level of divisional heads in the companies in his universe.

If you think about it, investors in distressed securities and activist investors try hard to put themselves in the position of being privileged investors. Distressed managers position themselves to be on the creditor committees which help decide how company financial reorganisations unfold. Activists seek Board representation. Being on the committee/Board puts them in a position of being better informed investors about the securities and companies to which they have exposure.

So a manager has information that he thinks is not priced into the market, even if he thinks several other investors know it too (the efficient market hypothesis being recognised as dead at this point). The information edge then has to be appropriately expressed in the fund's portfolio. This is where conviction and positive reinforcement should come in, but that is a whole other topic and would take us on to the dynamics of position sizing and portfolio construction – topics addressed in my consultancy but not here today.

Going back to when I was an investor in hedge funds at a fund of funds outfit, I used to ask managers of hedge funds in Europe about their information flows. I would only ask the managers in private meetings as this was not a topic for discussion in open forums like a Cap Into event. I don't recall a manager ever saying to me directly in this time (2001-2) that they had special or unique sources of information about stocks or companies. Finding out what the inputs to their process are is part of understanding how a manager operates. What sources they tap (and how frequently) is part of what helps you as an investor understand where the manager is on the spectrums: wholly fundamental through to wholly technical; long holding period investor through to short holding period trader; and where the manager is positioned in breadth versus depth in their universe.

So in conclusion, all hedge fund managers are required by investors to have an edge. Although the edge may theoretically be of different sorts (such as ability to forecast volatility or correlations, or time markets), often investors expect a hedge fund manager to have an information edge in some way. There is a significant bias amongst investors that the investment process of managers should be fundamentally driven, and this reinforces the desire amongst investors for an information edge to be part of the offering. In the pursuit of such an edge managers of hedge funds have made and continue to take significant initiatives to obtain for themselves proprietary information. Deep research and expertise justifies the (externally perceived) steep hedge fund fees. The trends are for hedge funds to devote more resources to acquiring the elusive information edge. Galleon allegedly did it the wrong way, but the information edge is worth persuing with most managers in the due diligence process.


The Posting A difference between long only and hedge has a comment on it.

Do you agree with Doug of London, or was he just talking his own book?