Simon Kerr on Hedge Funds

A Response from Con Keating to "The Truth About Hedge Fund Risk"

2012-01-31T19:31:00.000Z

This blog brought home many basic truths. However, I would like to emphasise a few points.

The question of volatility being inadequate as a measure of risk is the first. If we are to succeed in understanding financial risk we need to distinguish between symmetric and asymmetric risk. Symmetric risk – or volatility when returns are normally distributed – drives a wedge between the arithmetic average return and the compounded geometric return. It does so exponentially – for normally distributed returns, the geometric return lies 0.5% below the arithmetic when volatility is 10%, but 2% below when return volatility is 20%. The tendency is for symmetric returns to regress to the geometric return quite quickly. By contrast asymmetric returns are thoroughly pernicious – they return to the geometric return only very slowly, if at all – the obvious example which never returns is the total loss of the investment. This is why we worry about long tails on the downside and should love them on the upside.

The second concerns Omega functions as risk measures. In 2002, Bill Shadwick and I introduced a new performance metric known as an Omega function. Since then we have published widely on its statistical and mathematical properties. It is a simple pay-off function. The decision metric we advocated was that we should prefer high to low Omega but we cautioned heavily against its use at any single return level. In this blog response, we shall illustrate the nature of the problem using two elementary distributions, denoted A and B – the elementary statistics for these are shown below as table 1.

	B	A
Returns
	-4	0
	6	0
	6	0
	6	11

Average	3.5	2.75
Standard Deviation	5	5.5
Skewness	-2	2

Table 1: Two returns distributions and their elementary descriptive statistics.

By elementary mean-variance performance metrics, we should prefer B to A as it has both a higher return and a lower variance – the Sharpe ratios are respectively 0.7 and 0.5. Note, however, there is a pronounced difference in skewness, which may lead us to prefer A over B. The (log) Omega functions for these distributions, A and B, are shown as Chart 1.

Chart 1: Log Omega functions for distributions A and B.

Using the decision rule that we prefer the higher log-Omega function we see that we prefer A to B over a considerable proportion of the functions but there is a range in which B is preferred to A.

By translation and rescaling (T&R) of distribution B we may compare these two distribution function and arrive at Chart 2, which shows the excess return of B over A. The translation and rescaling was equivalent to adding 4.75% to B everywhere – the situation where B dominates A everywhere. However it is evident that (T&R) B only dominates A by a little above 3% on average and that this outperformance of (T&R) B over A is insufficient to offset the translation and rescaling effects applied to achieve complete dominance.

Chart 2: Return differences.

It is also sometimes helpful to consider what happens under a large negative shock. To illustrate this point we introduce a shock of -10% into the previous distributions A & B. The two distributions now have identical volatility. Chart 3 shows the log Omega functions for these augmented distributions.

Chart 3: Log Omega functions for A & B, with a -10% return shock.

Now we see that we prefer B to A everywhere below returns of + 4% and as B has a higher mean return than A we should prefer B globally.

Is Omega the answer to everything? No. It is only as good as the representativeness of its data with respect to the future. However, contrary to the regulatory mantra, past performance may be partially indicative of future returns performance.

Con Keating, January 2012.

The Truth About Hedge Fund Risk

2012-01-30T00:02:00.001Z

Article contributed by Charles T. Hage

Need for Truth

The hedge fund industry is seriously short on how it treats the subject of risk. The industry has been confusing investors by defining risk poorly and applying it post‐facto to returns. Especially in times when challenging economic and financial conditions call for high standards of professionalism to achieve success, the industry should be fine‐tuning all its mechanisms. Instead, in the core subject of portfolio risk, the hedge fund industry clings to misconceptions, is less than honest with itself, and misleads investors. The industry should rethink the role of risk in the hierarchy of investment decisions, embrace universally valid measures of hedge fund performance, and inject responsibility into the system for screening hedge funds. This paper is intended to explain why and how we need to rethink risk, and to suggest that if we do, the result can be to allocate capital to hedge funds more productively and profitably.

Before proceeding, note that GIPS (Global Investment Performance Standards) are designed to fairly represent and fully disclose to investors the performance information of a firm in aggregate. GIPS is concerned with how to value assets and calculate returns in all accounts managed by the firm, to ensure uniform, consistent reporting and valid comparisons at the level of the firm. By contrast, the present paper deals with the treatment and interpretation of given returns in a portfolio, and as such is distinct from and complementary to GIPS.

A full treatment of performance in hedge fund portfolios would incorporate time, without which frequency and correlation analyses related to a history of returns cannot be included. The author has chosen to forego time‐dependent analysis of returns because the focus here is on risk, which enters into each investment decision but is not a measure of performance.

Investor Satisfaction

As Peter Drucker said, “To satisfy the customer is the mission and purpose of every business.” He didn't mean to satisfy merely in the sense of pleasing, but in the sense of retaining clients, because business is clients. When it comes to satisfying clients who invest, George Soros' cardinal rule is to protect capital in difficult markets, and Benedicte Gravrand's key to active risk management is to keep negative returns few in number and small in amount. These are various ways of saying that investors want the fat (positive) head & thin (negative) tail distribution of monthly portfolio returns to which all good managers aspire.

That brings us immediately to big surprises, because nothing can ruin a fat head/thin tail faster than the unanticipated occurrence of a major event for which the manager has no effective response. An astute investor should ask the prospective manager "What is it about your investment strategy that insulates the portfolio from negative surprises and accommodates positive ones?" The answer may include a flexible strategy for leverage, an ability to liquidate positions rapidly, and limitations on participation in upside effects. Any talk of tail statistics has no place in the answer. The point is to focus on manager preparedness for surprises early‐on in the process of investor due diligence. Otherwise detailed discussions of risk analytics and risk management are uneasy and perhaps pointless. Little data may exist on how often surprises are dealt with up‐front by investors and managers, but human nature suggests it may be infrequently and inadequately. The lesson should be that unpredictability and lack of quantification do not excuse the manager from the task of dealing in advance with insulation from negative surprises.

Histories of manager performance have received infinitely more numerical attention than strategies for insulation from surprises. Unfortunately, the history of hedge fund performance analytics has produced a plethora of statistics and graphs without standards for validity of application or comparison of portfolios. Industry participants are therefore obligated to find the best content and form to convey performance clearly and meaningfully, with hope that means which excel will be broadly adopted. Here is one proposal for condensing historical data into a set of figures that efficiently characterize the portfolio performance of any hedge fund. Certain statistics commonly displayed in the industry are avoided here, not to simplify, but to avoid invalid and distracting measures.

These figures derive solely from returns and tell the performance story of a hedge fund. The first demonstrates how robustly the fat head/thin tail has been achieved. The second, with omega quantifying that robustness as a gain/loss ratio, plots fund performance as a single point against benchmark indices. The third depicts the fund’s combination of value added (alpha) and market sensitivity (beta) versus benchmark indices. The figures inform investors about performance of the fund and frame questions about how results were achieved, such as: What aspects of strategy offer inherently sustainable opportunity? What style and skills give the manager special performance advantages over peers? Under what rules is the portfolio managed to balance pursuit of opportunity and avoidance of risk? How did the manager anticipate and respond to major market events, and which monthly returns are related to those events? Note that risk does not appear in any of the return measures displayed in these figures. It is useful to discuss risks along with opportunities in the Q&A about risk management or the source of returns, but post‐facto "risk" tools serve no meaningful purpose, as we will discuss.

Since the figures relate only to the fund objective for return, investor tolerance for loss needs consideration. A simple approach is to quantify it in combinations of how much capital loss, and for how long, the investor will tolerate without redeeming. For example, the investor might tolerate 4 % loss for 7 months but not 6 % loss for 5 months. A discussion in such terms can determine whether tolerance for loss on the part of the investor and capital preservation criteria on the part of the manager are compatible. The need for such discussion underscores why capital preservation is not unilaterally quantified in the fund statement of objective.

The technical elements of the foregoing are not new, and the many aspects of investor satisfaction are easy to grasp. What compels exposition is the need for quality in the central exchange between investors and managers. It is challenging enough to convey clear and comparable assessments of a variety of complex investments before further elaborating with statistics to which the parties are partial. Any distortions or distractions are less harmful if introduced, inadvertently or knowingly, only after some central truth.

Portfolio Decisions

A person about to jump toward freedom across a deep rocky fissure understands opportunity and risk, odds and stakes, gain and loss. The act of leaping is elegantly simple, but the decision to do so accounts for all the conditions to be overcome and the consequences of failure. The relevance of such a situation may seem remote from investment decisions, but it's not. It's useful first to proclaim that there is but one reason to incur risk, and that is to pursue opportunity. In other words, without opportunity there is no reason to take risk, and yet portfolio risk has been analyzed ad infinitum and ad nauseam as a thing unto itself and after the fact. When we then ask why the word opportunity barely appears in the vocabulary about risk, we realize that the word decision also receives less than honorable mention. And that starts us thinking about how we've been thinking about risk.

Over two millennia ago, Marcus Cicero insisted that if you wished to communicate with him, you should define your terms, but every generation must overcome sloppy thinking that leads to confusion in the marketplace. Much confusion could be eliminated if we would all agree that opportunity and risk, each with its odds and stakes, are what might happen due to decisions not yet made, while gain and loss are actual outcomes after decisions are made. Every investment decision in the hierarchy of decisions among investors (e.g. manager selection) and managers (e.g. adjust leverage, buy/sell a position) is a dividing point between risk management and performance measurement. In particular, risk analysis to inform a trade decision by the manager helps to pursue portfolio success, but risk analytics applied to portfolio returns are useless because logically (1) they can't figure in any of the decisions made earlier that produced the returns, and (2) returns already booked cannot be at risk. By mixing risk with return for decades, financial theorists and practitioners have contaminated the thinking of managers, investors and service providers in the hedge fund industry.

This conclusion came from taking an exploratory path with little appreciation for where it would lead. What began several years ago as curiosity about hedge fund performance reporting led first to discovery of newer measures and then to examination of fundamental notions. Others are no doubt approaching the same kind of destination from different directions. For example, starting with the notions of fear (foregoing opportunity to avoid risk) and greed (ignoring risk to pursue opportunity) can lead to the same end point. The conclusion also came with the realization that herds are not exclusive to traditional investors; professionals in alternative investments may be a much smaller herd, but they constitute proportionately as many sheep and possess a level of influence that can do damage as well as good. More generally, deeply ingrained assumptions underlying widespread practice have a hold on minds that is hard to break. But as a friend was fond of saying: "Check your premises." Some may respond to the conclusion only by defending long‐standing, widely‐accepted scholarly teachings and professional practices, but those who developed or applied tools for risk in the past have earned our respect and we owe them a sincere effort on our part to rethink and improve.

Performance Measures

When his couriers privately reported to him on the news from Waterloo, Nathan Rothschild sold big and high in London, and the herd waiting for the same news eagerly followed his lead. Then, before slower official couriers arrived, he bought big and low. He had sent a false signal to traders that destroyed their wealth in a flash. Today, wealth in hedge funds is being destroyed not in a single dramatic episode but with false measures disseminated by the industry. Before reviewing how, it's helpful to make note of the predictive value of signals by taking a short side trip to the health care industry.

Galen & Gambino elegantly addressed the predictive value of diagnostic tests by quantifying how prevalence of a condition determines the validity of tests results. It turns out that a test with 90% sensitivity (1 in 10 false negatives; i.e. the test fails to identify 10% of sick persons) and 90% specificity (1 in 10 false negatives; i.e. the test identifies 10% of well persons as sick) has high predictive value only when you need it least, like in a full‐blown flu epidemic. But if 5% of a population has a condition, that test will produce nearly two false positives to match every true one. The prevalence of good hedge fund managers is debatable, but what investor wants to spend any appreciable time on due diligence of managers who are not truly in the top 5% and appear to be there only due to false positives? At the same time, investors cannot be expected to search through the chaff of the other 95% to separate wheat mislabeled with a false negative. Simply put, false signals in the current system can make Nathan look inconsequential.

Close to the heart of the matter is risk‐adjusted return. It deserves mention to reinforce the statement above that "risk analytics applied to portfolio returns are useless". Imagine that you perform final inspection on a manufactured product. You reject 15% of units, send them to a rework line, call the rest yield, and send that 85% to packing and shipping. The rework department is classifying rejected units by fault, identifying causes of faults, and fixing the faults; i.e. managing risk of failure in units yet to be made. Would you as final inspector use any "risk" number to adjust yield numbers in your reports to management? Of course not, for multiple reasons, but particularly because the process of risk management will "adjust" ongoing yield.

Risk has been assigned a vastly bigger role in assessing hedge funds than its companion opportunity. A major reason is its treatment for decades in risk literature, which has repeatedly equated volatility with risk. The familiar advice has been that between two funds with the same return and different volatility, pick the one with lower volatility; i.e. higher vol/risk should command higher return. The argument reduces to suggesting that in flipping a coin to win or lose identical objects, always choose apples over diamonds as the objects (same odds ‐ zero expected return; different stakes ‐ more vol/risk in diamonds). This is telling an investor with large resources to play a game of low stakes. The reasoning goes on to add that the choice demonstrates a need to adjust returns with vol/risk rather than let returns rest on their absolute basis. These ideas have been used to build a body of formulae for risk that leads in wrong directions. To his credit, Bill Sharpe has questioned the validity of his own formula.

Above all things, the hedge fund industry must apply portfolio performance measures that are beyond reproach. Existing measures have been challenged and better ones have been proposed, but entities that could be influential advocates for change in practice are so far largely silent. Gaussian assumptions and all their derivative statistics have lived long and well. It is time for them to go. Bell‐shaped curves are not an expression of investor interests. Standard deviation is not a proxy for risk and serves only to waste attention on the higher frequencies and shorter durations of price variations, distracting attention from longer term ends and means. Ratios incorporating standard deviation are useless for reasons given above.

The Omega function (Keating & Shadwick) has emerged (2002) to quantify the robustness (quality) of a distribution of returns. It captures all the data in any shape of distribution and preserves validity by avoiding any and all premises. It has universal appeal as a measure that is intuitive, important and uncontrived. In its simplest form as a single ratio balanced about a zero‐return fulcrum, it is eminently more useful than all the "risk" statistics currently derived from returns. It leverages aggregated monthly gains against aggregated monthly losses, indicating how well opportunity/risk prospects have been managed to satisfy a capital preservation objective. In any quantifiable endeavor, that kind of data analysis appeals directly to the fundamental need for measurable objectives.

Screening Hedge Funds

Screening can be more important than selecting in the same sense that defining options can be more important than the final choice among them. A selection will be optimal only if the best option is on the table and that will happen only if measures used for option attributes and search criteria are valid and matching. The goal of any screening step is to put an option on the table if and only if it meets the criteria. With that goal met, successive screening steps can reliably arrive at the start of selection through due diligence. The hedge fund industry is not within sight of that Utopia. Working toward it will involve commitment and participation from experts, managers, platforms, consultants, databases, associations and conference organizers as well as demands from investors. Major effort over time will be required to develop a system that directs investors toward better allocation of capital to managers.

How big a payoff can be expected from this kind of effort? A system that tracks visits by accredited investors to leading online hedge fund databases has shown that the number of unique visitors to the top three sites is running at monthly rates of several thousand per site. Visitors who are unique within sites are not all unique between sites, and visitors make multiple visits, only some of which are to perform a screen, so there are ups and downs in any attempt to estimate the magnitude of screening done online. But even if we modestly assume 10,000 screens per year in total and modestly suspect that on average a screen produces one false positive fund or one false negative fund, it is easy to visualize how capital and profits in the billions of dollars could be lost over time as a result of suboptimal selection from among funds that survive flawed screens.

Industry Action

We have considered why the hedge fund industry must rethink risk and have identified elements of correction, but that does not constitute a roadmap for revision. A few years ago Bill Sharpe told Con Keating that Omega Ratio was ahead of Sharpe Ratio in terms of acceptance at a comparable age. That's encouraging in particular, but the general situation calls for leading advocates to step forward and develop a framework for broad‐based change. The integrity and practicality of the industry are presently at risk and in need of rescue with the help of some truth.

About the Author

Charles T. Hage is currently Compliance Officer at Mohican Financial Management, LLC. During his career he has reviewed financial performance measures in alternative investments and managed financial risk in corporate investment programs.

References

Hedge Fund Radio on the 30th January

2012-01-27T15:51:00.002Z

Hedge Fund Radio on the 30th January 2012

Make sure you listen out for the Monday, January 30th edition of the twice Sony Awards-nominated N@ked Short Club on Resonance FM [104.4FM within London/online worldwide on the internet here]: 1 hour of loose talk about hedge funds and the state of the world, plus sweet poetry and heady music...No promotional agenda, no commercial intent...just Ponzi Bier and Pure Alpha both on tap.

Host, Dr. Stu will help callers to the Emergency Hedge Fund Helpline (1-800-DISTRESSED) to re-evaluate their Inner Mark to Market, with expert guests: Dr. Peter West- PAM Global; Adam Sorab- CQS; Richard Watkins- Liability Solutions; James Parker- Aravis; Simon Kerr- Enhance Consulting/the Simon Kerr Blog; Sam Jones- The Financial Times; Amelia Colvin- Gerson Lehrman; plus by Tantric Videolink from the US, Mike Gasior- AFS.

The show is broadcast between 9-10pm/ 21.00-22.00 hrs., London time.

Millennium Capital Leads the Large US Managers in Europe

2012-01-24T11:51:00.002Z

One of the consequences of the Credit Crunch of 2008/9 was a scaling back by hedge fund managers – they cut their gross, they restricted redemptions, and, in managing their companies through a traumatic period for the industry, the larger managers often reduced headcount or closed their offices in Asia and London. When there were strategic cost saving measures made post-2008 it was more likely that the Asian outpost of a US hedge fund group would be scaled back rather than the London office. Often there was a pause in hiring in Europe – as seen in the time-series of the number of Approved Persons* registered with the UK’s FSA for Davidson Kempner European Partners and Moore Europe, graphics 1 and 2 below.

Graphic one: Headcount of Approved Persons (Staff Registered with the Regulator) at Davidson Kempner European Partners in London Since 2004

Source: Financial Services Authority Register/IMAS

Graphic two: Headcount of Approved Persons at Moore Europe Capital Management since 2004

Source: Financial Services Authority Register/IMAS

Less typical in management of headcount of the US firms with London offices was Steve Cohen’s SAC, which had operated in London since the turn of the century through Walter Capital Management. SAC scaled back the investment, compliance and senior management staff in its London operations (renamed S.A.C. Global Investors) by about a third in 2008/9, as graphic 3 below shows. As events unfolded and financial markets returned to something more like normal in the years after the Credit Crunch, SAC increased its headcount in London, just as it did in its Connecticut headquarters. The expansion phase post-Credit Crunch at SAC in London included the re-hiring of some traders let go less than a year previously.

Graphic three: Headcount of Approved Persons at SAC Global Investors in London Since 2004

Source: Financial Services Authority Register/IMAS

Staff numbers at SAC in Europe have continued to be managed on a flexible basis, in that the Euro shock of May/June 2011 coincided with the peak in professional staff, and a net 8 traders and other professionals (those that have be registered with the FSA) have left since. It could be said that SAC has been particularly proactive in managing its head count to short term business conditions compared to most US managers with London offices.

Graphic 4 is a table showing the American hedge fund firms with the 20 largest staff teams in London. Only four firms (Moore Capital, Millennium, Citadel and Tudor) have 40 or more traders and portfolio managers based in Europe’s financial hub. Only 13 US-controlled hedge fund firms have professional staffs of 20 or more, as reflected in Approved Persons registered at the FSA. And by inference, less than 20 American hedge fund firms have total staff numbers of 30 or more.

Graphic Four:

The 20 US Controlled Hedge Fund Groups With the Largest London Headcount At The End of 2011

Source: Financial Services Authority Register

Looking at just the 30 American-owned hedge fund firms with the largest London offices, Table 5 ranks the firms with the largest increase in headcount over the last year. Across all 30 of the funds analysed in detail professional staff numbers went up by a modest 6% in 2011. This is only a few dozen staff across all the firms covered, and a third of the surveyed firms showed exactly the same (professional) headcount at the end of the year as they did at the beginning. So the overview is one of stability in market-focused human resources for the European outposts of these firms, with some modest expansion at a minority of hedge fund management companies.

Izzy Englander’s Millennium Capital Partners is the standout. The firm has been in expansion mode on the back of good results – its Millennium International Fund was up over 8% last year. It turned out to be good timing for the firm to hire its first head of marketing, John Novogratz, in the first half of last year, and he had some early wins as firm-wide assets went from $9.2 billion to $11.6 billion in 2011. The increase in AUM over 2011 has given scope to add to capacity in Europe, and Millennium has added 22 FSA registered staff members including traders.

Graphic Five: Ranking of Change in Headcount Amongst UK Staff of American-Controlled Hedge Funds

Source: Financial Services Authority Register

The absolute numbers of staff added are not large for most of the firms in Table 4 and 5, and so there is some reluctance to draw inferences for most of the firms cited. That written, firms that trade as much as invest for a living are a feature of the ranking of firms in expansion mode – SAC, Tudor, Soros Fund Management to an extent, and Millennium.

On the other side of the coin, Table 6 shows the American hedge fund groups that that shrank their professional staffs over the last year.

Graphic Six:

Ranking of Change in Headcount Amongst UK Staff of American-Controlled Hedge Funds - Declines

Source: Financial Services Authority Register

Again the changes in numbers are small in absolute terms, so frictional turnover may account for the changes in staffing in Table 6 and the shrinkage may not necessarily be through management decision making. The only generalisation drawn is that event driven managers are a feature of the list, and give what has happened to markets in 2011, a large reduction in public market transactions makes resource re-balancing in that strategy understandable.

American Management Compared to European Management

Finally, there is a comparison available for how the top American hedge fund managers manage their London-based offices compared to the top European hedge funds. In November an analysis of the staff registered with the FSA for hedge fund groups indigenous to London was carried out here. The analysis of Europe’s top managers covered the changes in human resources over the year to the end of August 2011. By one of those strange coincidences, the top managers in London in aggregate had added 6% additional professional investment staff over that period of 12 months, the same percentage as the top 30 US-controlled firms have added over the last year.

Employment is a lagging indicator in macroeconomics, and the hedge fund industry is no different in that business conditions have to be stable for some time before managements assume the risk of adding to their cost structure for staff. Provided that December redemptions are at the level indicated by the industry scuttlebutt (GlobeOp data and the like) it can be assumed that we will see a steady if unspectacular increase in hedge fund employment in London in the first half of 2012.

* Approved Persons are those registered with the Financial Services Authority to carry out regulated activities – all partners in a partnership and those carrying out specific duties, such as CFO, CEO, senior operations staff, compliance officers, and traders and portfolio managers. Staff not registered at the FSA can nearly equal in number those registered with the UK’s financial regulator where firms have local middle and back office operations, a marketing presence in Europe and/or risk management and technology staff.

The Big Hedge Fund Stories from 2011

2012-01-04T23:47:00.002Z

Although individual news items can have can have historical significance (such as story 1 below) the effort here is more to point to the themes and trends at work in the hedge fund industry last year. Here are my top stories for 2011:

1. Big Name Retirements – two of the best known names in the business stopped running other people’s money in 2011. George Soros turned Soros Fund Management into a family office in the middle of the year, allowing him to have some involvement, even if he is not the CIO at 81 years of age.

Bruce Kovner has handed over the investment reins at Caxton Associates to Andrew Law, and the macro maven is retiring. The extent of his future involvement in the $9.4bn firm is not clear at this point.

2. Regulatory Body Success in Prosecutions – after much effort over the years, regulators in the United States got some hedge fund scalps of significance in 2011. After the SEC was criticised for its handling of allegations against Pequot Capital Management, the Securities and Exchange Commission need the conspicuous success it achieved in the convictions against the employees and owners of Galleon Group. Galleon founder Raj Rajaratnam was convicted of insider trading and sentenced to 11 years in jail in October. Galleon trader Zvi Goffer, who controlled two insider dealing rings, was sentenced to 10 years in prison and ordered to pay more than $10 million in forfeitures.

The other conspicuous success was the case brought against Chip Skowron, portfolio manager at FrontPoint Partners. The healthcare stock specialist was convicted of insider trading in August and sentenced to 5 years in prison.

3. A Hedge Fund Winner From The Euro Crisis – that classic global macro management can still be effective was demonstrated by Kyle Bass (and Hugh Hendry) last year. Kyle Bass, the principal of Hayman Capital Partners, made capital (both monetary and reputational) out of the sub-prime mortgage imbroglio of 2007-8. It required patience and the ability to structure the trade right. Having demonstrated that trait and that ability in making great returns then, in 2008, Kyle Bass went on to talk about the potential for the indebtedness of some European countries to become an issue of significance. He also identified that the long-dated credit default swaps were a great way to give low cost of carry and a big pay-off. Bass’ patience and insight were rewarded in returns when the structural flaws of the European project became clear to everyone in 2011.

The classic global macro set-up of a structural imbalance and an option like pay-off was also successfully used by another contrarian, Hugh Hendry. Hendry shares with Kyle Bass a wariness of fiat currencies, but his pay off in 2011 came from sharing the trait of patience. The manager of the Eclectica Fund had pointed out some problems with the phenomena of Chinese growth in 2008, and in 2010 he began last year to short highly-cyclical Japanese corporate credits with high exposure to Chinese demand. The Eclectica Fund was up over 12% for the year by early December of last year.

4. King Quants Come Back – several of the hedge fund industry leaders made money for their investors applying quantitative techniques to markets, but the crowns of these kings of the algorithms have been tarnished by the aftermath of the quant shock of August 2007. The archetype has been the Goldman Sachs Global Alpha fund. The two founders of the research process behind the product, Mark Carhart and Raymond Iwanowski, left Goldmans in 2009, and the fund itself was closed in the fourth quarter of 2011.

But not every quant outfit has followed a route of inexorable decline. It was commented here last year (see this article) that Renaissance Technologies, founded by Jim Simons, was back on form, and the Renaissance flowering was sustained into 2011. The Renaissance Institutional Equities Fund International Series B was up 32.47% through the end of November 2011.

The quant turnaround of 2011 was D.E. Shaw & Company. The firm had had a rough time post credit crunch – for a longer exposition of the decline in assets see this article. Asset growth is a function of returns, and returns for 2011 were excellent at D.E. Shaw: the firm’s multi-strategy Oculus fund was up 18.3% for 2011 (through the end of November), and the flagship Composite Fund was up 3.8% over the same period. AUM at D.E. Shaw went from $14bn at the end of 2010 to $16.5bn in the 4Q of 2011.

5. Closing to New Capital Reflecting Industry Concentration - the big have continued to get bigger in 2011, just as they have previously. But in 2011 the long-term trend was reflected in a phenomenon that was welcomed back like discovering an old friend who was out of contact for a long while – closing to new capital.

An early indicator in the year came when Cevian Capital announced that they were capping Cevian Capital II. That produced a wry smile of recognition for the return of the phenomenon, but it came to feel like it was contagious when indications came in May from SAC Capital Advisors that it was considering closing to new money (the actual cut-off point was August 2011), and in the same month Daniel Loeb closed Third Point Partners to new money with AUM of over $7bn. Good examples of the way flows were directed came in Europe at CQS and in the States at Sandler Capital Management.

In June 2011 CQS announced it was closing the CQS ABS Fund to new money. But what was more indicative was that the firm's total assets had almost doubled over the previous year-and-a-half ( to around $11 billion). Inflows at the aggregate level stopped half way through the year, amid the turmoil in Europe, but at the micro level the announcements kept on coming. In October New York-based Sandler Capital Management announced a six moratorium on new capital to its long/short hedge funds while it digested a tripling of assets over the previous 18 months.

Newer and smaller firms were also closing to new money (Edoma Partners, JAT Capital Management and Taylor Woods, for example), but the increasing concentration in the industry was reflected more by the announcements by the brand name managers. The news flow on major manager closings continued to the end of the year as Viking Global Investors announced it was closing Andreas Halvorsen’s flagship fund, Viking Global Equities, to additional capital.

6. The Volcker Rule Leads To Big Trader-Led Launches – the Volker Rule separating prop trading from the rest of investment banking came into law in July 2010, and put real juice into the launch calendar in 2011. Given the lead times to set up businesses, it was inevitable that the impact on the hedge fund industry would come in 2011, and many in prime brokerages have stated that they have seen the best quality pipeline in years as a result. Here are some of the more notable ones.

The epitome of launches from former prop traders was Hong Kong-based Azentus Capital, set up by Morgan Sze, who had headed Goldman Sachs Principal Strategies Group there. The fund launched with a billion dollars in April, an unusually large day-one size, but very unusual in Asia. And in an echo of the glory days of the hedge fund world, the Azentus fund doubled in size in four months and closed to new money.

A notable launch by a prop trader in 2011 was by Tony Hall – a trader with a good reputation. In his last year at Credit Suisse he had generated one of the most profitable books ever seen at the bank. Working with the Duet Group he launched a commodities focused hedge fund in early 2011 which was up over 27% after 10 months. Avantium Investment Management was founded by a team of executives from Deutsche Bank headed by Kay Haigh. Having traded emerging markets for the bank, they launched their Avantium Liquid EM Macro Master Fund onto the world in October.

Another fund launched to invest in commodity markets came from Taylor Woods, a management company set up by a 7-strong team of former traders at Credit Suisse led by Beau Taylor. With launch capital of $150m from Blackstone the Taylor Woods Master Fund made positive returns in 2011 by engaging in commodity arbitrage, particularly in energy markets.

A fund launch from ex-prop traders which reflected another trend for start-ups in the industry was Benros Capital Partners in London. The principals of the firm, Daniele Benatoff and Ariel Roskis, are alumni of Goldman Sachs who launched their European event-driven fund in the 2Q of 2011 with backing from a firm seasoned in the hedge fund industry. Stockholm’s Brummer and Partners were the first hedge fund company in Northern Europe, and have helped into business a string of hedge fund companies through part ownership of the management companies. In the case of Benros, Brummer own a chunk of the equity in return for seed capital of $300m.

7. Two Sides Of The Performance Race -Bridgewater outperforms (again), and some big name equity managers falter. After producing a return of up 27.4% in 2010 in its Pure Alpha Fund, Bridgewater Associates’ Ray Dalio described that outcome as a one-in-twenty year event. Given that in 2011 over the year to end November HFRI Fund Weighted Composite Index was down 4.6%, that probably makes the sequence of +27.4% for 2010 followed by +15.92% for 2011 (to end Nov) for Bridgewater’s flagship fund a once in a century series of events. While statisticians will claim that given 9,000-plus hedge funds there is bound to be a fund with these good-but-unlikely results – an argument used to negate Warren Buffett’s achievements – realistically one must congratulate Bridgewater Associates for taking advantage of some great market background for their big picture style of investing.

The same cannot be said for equity long/short managers in general. The HFRI Equity Hedge Index was down 7.39% for the first 11 months of 2011. Against this benchmark and over the same period the underperformers amongst the larger managers were Kingdon Capital Management (-18.15%) and Lansdowne Partners’ UK Equity Fund (-19.8%). It may not be taken into account fully by investors in equity hedge funds, but in contrast to the opportunity set for Bridgewater, the equity markets were down on the year in 2011 and the see-saw pattern they traced in the second half of the year – no direction but with high volatility – is an adverse market background for most equity long/short managers as they tend to be structurally long biased, and the larger ones have to be biased towards investing rather than trading.

The most noteworthy underperformer of the year amongst the mega managers, the range of funds run by Paulson & Company, has been well covered elsewhere.

The stories that didn’t quite make the list above were on the Shumway Capital Partners restructuring and the rise of seeding capital and seeders in 2011. If you would like to suggest other stories and themes that were characteristic of 2011 please use the comments input field below.

Translations of a Due Diligence Meeting for a Hedge Fund

2011-12-23T11:36:00.000Z

A well prepared due diligence meeting has a subtext. The following translations will help hedge fund managers understand from where their interrogators (and potential investors) are coming.

Do you have any plans to add any employees? (Do you plan to re-model your house in the near future or are you going to back the growth of your own business?)

How concentrated is the list of your current investors? (We know if GAM pull you are you f****d)

I see you use an external compliance consultant. (I see you think that a small retainer to former FSA staffer can replace a core internal activity of an asset management business)

Is there a particular reason for the risk manager to be located in the annex? (We have spotted how frivolously you treat risk management that is not in your head)

Can you talk me through how you coped with October and November 2008? (What wholesale changes have you made to your risk controls to make sure that disaster zone of a return doesn’t happen again?)

Can I talk to your head of operations about that? (You clearly know nothing about what the back office does)

What was the background for your former partner to leave last year? (Who had the biggest ego between the two founders?)

Who bought the pictures in this meeting room? (Whose taste is THIS?)

These are nice offices and a great location. (This is a big overhead for a small business)

What a friendly dog! (Having the principal’s name over the door was not just the default choice)

What is your experience of using this system for operations? (I’ve never heard of this supplier)

Can I deal with you directly from here on? (This third part marketer is a piece-of-work)

Hedge Fund Returns Are Path Dependent - As 2011 Illustrates

2011-12-07T16:07:00.001Z

One of the things that is attempted on this website is to look at market action to help explain, or comprehend hedge fund returns. For example, two years ago a commentary was distributed on the significance of the quality factor in explaining returns in 2009 (see this article), and the impact of high correlation this year was explored (here) too. This year has been a very unusual year in the macro background and in how markets have moved - year three of a recovery does not normally look like this one in economics or markets.

The market events of this year have been a slalom course for hedge fund managers to negotiate (risk on/risk off), and the hedge fund indices reflect that. The HFRX Global Hedge Fund Index was down 8.58% for the year up to Monday (the 5th of December), and directional funds have fared a lot worse than non-directional strategies (the former are down 18% on an index basis).

Manager letters can be a good source of market context for hedge fund returns. In particular managers taking a quantitative approach are risk aware by nature and typically have a numerically stronger way of expressing the market conditions, and the suitability of their own methodology for extracting value from them.The overview reproduced below comes from Quant Asset Management of Singapore, managers of a portfolio of global equities.

Dear Investor,

It is unusual for us to add any written text to our monthly email other than the standard text in the newsletter. Since we apply a consistent, systematic investment methodology, once familiar with the methodology, the newsletter is normally self-explanatory. But because we are currently witnessing the biggest draw-down since the inception of the QAM Global Equities fund, 71/2 years ago, we’d like to use this opportunity to share some of our thoughts on this.

We now had a period of seven consecutive negative months with the fund being down 22% for the year. The main reasons for the negative performance are:

1) We use mostly fundamental factors when selecting our stocks from a global universe of over 6000 stocks. Fundamentals haven’t been driving markets in the past seven months. Macro-economic factors were driving markets and correlations have been at an all time high.

2) We use a trend following methodology that adjust factor weightings each period for what worked well in a certain past period (dynamic) before. This didn’t work well in the past seven months due to volatility spikes and trend reversals.

3) We use a hedging methodology whereby we are either 0% or 50% net exposed mostly based on aggregate earnings revisions number and some price performance related techniques. This hasn’t added value in the past seven months.

So the question arises if our methodology is still valid and when will it work again?

First of all; all good investment methodologies go through periods where they struggle but as long as they add value over time and make logical sense, it makes sense to stick with them in order to achieve above average returns.

Furthermore we believe that systematically picking a large number of stocks on the basis of fundamentals (valuations, earnings growth and earnings revisions) combined with a factor adaption methodology, whilst hedging out a large part of the market risk, does add lots of value. Remember that the fund is up 154% since inception. This compares to 16% for the MSCI World in the same period.

We have always allowed volatility in our funds (around 20%, which is much more than most of our peers) in order to achieve higher returns than our peers. These high returns have been achieved and we have a strong belief that they can be achieved again. In order for this to happen one has to allow certain periods of under-performance. Draw downs are pretty natural and frequent in fundamental factor adaptation systems and one should be reminded that they can create opportunities too.

Kind regards,

The QAM Team

The letter is reproduced here to give some insight to market drivers of return this year, not to point fingers at a style or a particular manager. The general point is that the vast majority of managers take a specific approach to markets that they hope works most of the time and for most market conditions. The marketing conceit of an "all weather" hedge fund or strategy died in 2008. The returns delivered by a manager are a function of their own style and the opportunity set available from the market over the period. It is very striking that the gyrations of markets in 2010 and 2011 made it very difficult for equity hedge fund managers to make positive absolute returns except when the equity market letter was written by the Fed and other central banks through the mechanism of QE2 (from August 2010 to March 2011).

Hedge fund returns are path dependent, not independent of the direction of markets, nor independent of changes to intra-market or inter-market correlation, nor unaffected by the extent to which markets trend. The specific sequence of ups and downs, step-wise shifts in volatility, and how long a market regime lasts impacts the ability of the manager to harvest alpha in the way they are set up to address markets. So, for example, it would not just be relevant that markets were down 5% over a six month period, but in understanding outcomes it is more relevant that they appreciated by 11% over six weeks before losing 15-16% over 4 months (with specific volatility and correlation conditions).

It is up to the investor in hedge funds to put together portfolios of funds which take account of the various market conditions which may occur, in full knowledge of the manager style. Building such an efficient portfolio of funds can only be achieved when investors truly understand how their capital is being applied to markets by their managers. Provided the managers stick to their expressed style, there should be a limited number of surprises to investors in hedge funds given market conditions, and how market conditions change (the specific path markets follow). For any given market conditions and sequences the better investors in hedge funds will have a range of expected return per manager in which they are invested. As yet, the path dependency of hedge fund returns is not sufficiently well appreciated - spread the word.

UCITS III Footnote - the offshore fund from QAM was down 23.49% over the period end Feb 2011 to the end of November. The onshore equivalent - Quant Global Equities fund, a sub-fund of the Quant AM SICAV (a UCITS III type fund) - was down 27.77% over the same period. The onshore version launched in March this year.

Winton's Futures Fund is primus inter pares

2011-12-01T14:54:00.001Z

There has been a lot of comment in the hedge fund industry on the asset gathering of Winton Capital this year. David Harding's firm has attracted inflows of over $7bn in 2011, which equates to over 10% of the whole industry's capital inflows. This is a remarkable market share of the growth for an industry of over 9,000 funds for investors to choose from.

There has been some commentary that the success of such brand-name big managers is down to the dominance of American institutional flows to the industry, and the limited vision of the investment advisors to those funds. There has been less consideration of the investment performance of the winners.

The tables below come from CM Capital Markets, a Madrid based CTA. Their fund is called CapiTrade Systematic Global Futures, and since they put together and distributed this analysis their three year old managed-account-turned-fund must stack up well on CTA performance criteria. And it does.

But so does David Harding's Winton Capital over the period covered (May 2008 to October 2011). It has been well observed that Winton scaled back risk assumption on their funds during the Credit Crunch, and that since then the funds (Futures Fund and Evolution) have been run with lower risk levels (leverage). It is therefore logical in down-years for the strategy that the Winton funds have smaller losing months and more shallow draw-downs than peer funds. But the success in producing returns this year go way beyond the conservation of capital.

Winton Futures Fund has done better than the peer group in several ways this year: 7 out of 10 positive months (versus 3 for the Newedge CTA index), a worst-monthly-loss in that time of half of the typical loss of competitors, and a positive year to date return when most CTAs have struggled to make money.

Extending the data window back to May 2008 brings BlueCrest's BlueTrend Fund into the frame as a serious competitor on the basis of performance. Leda Braga. who runs BlueTrend, is proud to state that she has never reduced the risk appetite of the fund. This has enabled BlueTrend to produce higher absolute returns than Winton over the last 40 months, though with a higher level of volatility. If an investor is willing to take the higher volatility of return and risk assumption, then BlueTrend is a viable alternative to Winton Capital 's Futures Fund. But for the more conservative (by risk appetite) investor Winton Futures Fund is primus inter pares.

Post Script of 2nd December:

Thanks to the two managers mentioned in the above article that came forward with amendments to the data given above by CapiTrend. I should reinforce the point that the returns for 2008 in the above table were supposed to be those from May to December of that year. The returns for some leading managers for the whole of 2008 were:

AHL up 29%

BlueTrend up 43%
Millburn Diversified up 22.36%
Winton up 22%

In addition, other data quoted for Millburn in the above tables are not recognised by the Millburn Ridgefield Corporation themselves. BarclayHedge gives the annual return series for the Diversified Fund as 2008 22.36%, 2009 -7.38%, 2010 12.58% and 2011 (to Oct) as -6.75%.

Apologies to the relevant managers from me for distributing erroneous data. I hope the thrust of the article still applies, and there is a lesson in this about the source of data and the (mis)use of it!

Hedge Funds Positioning to Benefit from Euro Banks Spitting out Assets

2011-11-22T16:27:00.007Z

"The Economist" (19th November 2011 edition) has just written about the market for assets being spat out of European banks. The article is reproduced below. For my part I see the market for leveraged loans in Europe becoming very attractive to buyers who know how to be selective, with, unlike the bank asset story, an inevitability about it. So part two of this article is my rejoinder to that in "The Economist".

Waiting to turn trash into treasure

“THIS is going to be the next great trade,” one American hedge-fund executive effused early this year. For more than two years funds have been salivating over the slew of assets that Europe’s banks will have to sell. Many have been opening offices in London and hiring to prepare for this “tidal wave” of opportunities.

Up for grabs will be distressed corporate loans, property debt and non-core businesses as European banks shrink their balance-sheets to meet stricter capital requirements. Huw Van Steenis of Morgan Stanley estimates that banks will have to downsize their balance-sheets by €1.5 trillion-2.5 trillion ($2 trillion-3.4 trillion) over the next 18 months. Funds have only about $150 billion to spend on distressed debt in Europe, he reckons, which means they should have their pick of assets.

For now the “next great trade” is not looking that good, mainly because there have been no fire sales. Most banks that are selling assets have priced them close to face value, providing little to entice buyers.

Even where sales are agreed, financing is scarce. In July Blackstone, a large alternative-asset manager, agreed to buy a £1.4 billion ($2.2 billion) real-estate loan portfolio from Royal Bank of Scotland, but has yet to raise an estimated £600m to pay for it. Worse still, many banks may not be able to sell assets cheaply even if they wanted to, because it would force them to take losses that would erode scarce capital.

"We’ve been lying in wait for this opportunity since 2008. But it will come piecemeal. It will take years and years and years,” says Joe Baratta, head of European private equity at Blackstone. Some predict that Europe could go the way of Japan’s glacial deleveraging and take a decade or more to clean up its banks. Politics play a role too. European politicians, no hedge-fund lovers, won’t want to see them buying up assets at truly distressed prices and profiting from Europe’s gloom. It may even be “politically impossible” for banks that got a government bail-out to write down assets significantly, says Jonathan Berger, the president of Stone Tower, a $20 billion alternative-asset firm.

What could turn things around? Some fund managers hope a plan to recapitalise Europe’s banks to the tune of €106 billion by next June will at last force disposals at banks. So too may the introduction of Basel 3 rules that will require banks to hold more high-quality capital. Marc Lasry, the boss of Avenue Capital, a distressed-debt hedge fund, wants to buy from these “forced sellers”, because they will offer lower prices.

Banks aren’t the only prey that funds are hunting. A wave of refinancing that will hit private-equity-owned firms over the next few years may prove profitable for distressed-debt funds. And plans by some European governments to privatise infrastructure assets may also be enticing.

In the meantime, inventive fund managers are figuring out other ways to do deals. Some, such as Highbridge, a large American hedge fund that is owned by JPMorgan, and KKR are scaling up their lending operations as banks cut back. They are able to charge high interest rates, because companies are desperate for cash.
Banks are being inventive too. Unable to sell assets, they have come up with a compromise of sorts, and have started agreeing to “synthetic risk transfer” arrangements with hedge funds. For example, BlueMountain Capital, an American hedge fund, has agreed to take on some risks on a credit-default swap portfolio from Crédit Agricole, a French bank. Another hedge fund, Cheyne Capital, has reached an arrangement with two big banks in Europe to take the first 4% or so of losses from a securitised portfolio of loans, in exchange for a very healthy return.

For those hedge funds set on playing Europe, the main dilemma they face is how long to wait before buying. Steve Schwarzman, the boss of Blackstone, insists that it is important to stay put. “It’s like dating someone,” he says. “You can say let’s wait two years. But she probably won’t be around then.”

Comment from Simon Kerr

The deal flow resulting from the partly state-owned British banks reducing their assets has been slower and smaller than many expected. This is partly because the banks have effectively lobbied to have new capital adequacy regulations phased in over a longer period than first thought, and because the regulations which seem onerous in high principle on their announcement seem less so when the detail means of implementation locally are made public. In sum, along with accumulating retained earnings, there is less risk of a capital shortfall for these banks than there was, so the pressure to conduct asset sales does not come with a visible deadline.

Arguably the same could not be said for the European market for leveraged loans. The peak of loan origination, the previous peak of bank-financed M&A, was in 2007 - see graphic 1.

Graphic 1 - European Leveraged Loan & High-Yield Bond

New-Issue Volume

source:S&P LCD

The recovery of issuance in 2010 versus 2009 was not as constructive as it at first looks for total volume. Nearly two thirds of all leveraged loan and bond issuance in 2010 was to refinance existing debt, whereas in 2007 the proportion was approximately 20%, when new buyout and recap activity dominated.

The economic environment over the last few years for European companies with leveraged loans is reflected in the default rate. Graphic 2 shows the inverse relationship between economic growth (with a lag) and the rate of defaults amongst companies using leveraged loans as part of their balance sheet.The inference of the two graphics of default rates is that some of the European takeover deals which are above average for size that have been financed by leveraged loans are beginning to unravel.

Graphic2 - Default Rates for European Leveraged Loans

source: S&P LCD

That recent change has been a small negative is picked up by data for companies that are seeking to renegotiate their borrowings with their lenders. Graphic 3 shows a low level of restructurings and renegotiations, but against a background of some economic growth in Europe.

Graphic 3 - Number of new restructurings and covenant resets – European leveraged loans

source: S&P LCD

So there has been a build of new loan issuance in Europe to a peak in 2007 and then a large falling away of new issuance, except for re-financings. However, bank loans are not permanent capital, and the companies that take out the loans intend to re-pay them within 3-5 years and replace the loans with cheaper longer-dated financing when they can. However the state of the capital markets, and the conditions of the banks have both made this intended next phase difficult to execute. The consequence is that there is a maturity wall for leveraged loans beginning in the year after next - just 14 months away, if you needed reminding. The wall is illustrated in graphic 4.

Graphic 4 - Maturity & Rating Profile of Outstanding European Leveraged Loans

source:Fitch

Fitch estimates that of the companies they provide shadow ratings on in Europe (approximately 300 borrowers representing €240bn debt), 60% by value is due to mature between 2013 and 2015. Just over half the debt currently has a shadow credit rating of B or above with an average leverage of up to 5.4x. On the basis the high yield bond market continues to support strong rates of issuance, these loans are more likely to be refinanced in a conventional manner. The remainder, €117bn, is shadow rated B- or worse and with a current leverage on average above 6.5x represents "a significant challenge" to refinance in today’s credit markets.

PwC has commented that "The ability to refinance this wave of maturing loans is made more challenging by the fact that the majority of CLO investment vehicles (which were a key driver of market liquidity in the boom years up to 2007) will cease to be able to reinvest their funds just as the quantum of maturing loans reaches its projected peak...We expect that the majority of healthier corporates will be able to use high yield bonds and new leveraged loans to address their upcoming maturities. However, we expect there will be a significant number of companies who are forced to enter restructuring negotiations to resolve upcoming maturities."

So the European market for high yield and leveraged loans has some serious indigestion problems ahead of it. This will create some gross mis-pricings as the weight of paper needing refinancing relative to the size of the buyers is a considerable mis-match. Those buyers that are still active in the market will be able to be very selective, and they will have many opportunities and considerable work to do as the restructurings start to happen.

Some market participants are starting to get ready now. GSO Capital Partners, the global credit management arm of Blackstone, only last month acquired the largest manager of leveraged loans in Europe, Harbourmaster Capital. The AUM of Harbourmaster, at €8bn will be attractive to GSO/Blackstone, but the juice in the deal is the capacity to analyse the opportunities that will arise as the wall of maturities approaches. This area of investment is not one in which one can acquire the necessary understanding quickly by adding a few bodies. Having a large team (40 professionals in the case of the new combined entity) will give GSO a capacity advantage that will belong only to them and the other early movers yet to emerge. This is an excellent strategic deal on Blackstone's part.

Addendum
6th December 2011:

MKP Capital Management LLC, the New York-based global macro and structured-credit hedge fund with $4.5 billion in assets, is starting a credit team in London to invest in European debt. Steven Jeraci, a partner at MKP, will relocate to the firm’s London office to hire investment professionals and build the team’s infrastructure, the hedge fund said in a statement today. The team should be in place by the end of next year, the company said.(source: Bloomberg News)
Comment - the fact that a team will be put in place by the end of 2012 says something about when the opportunity to commit capital will be ripe for exploitation, and reinforces the point that to build a quality team will take some time.

Addendum
25th January 2012:
Mesirow Advanced Strategies Inc., which allocates $14 billion to hedge funds, has been increasing the amount of cash it holds in the last couple of months in preparation for potential opportunities including those in the European credit markets. “What we want to have is the flexibility that if particular things do deteriorate, we can play offense relatively quickly, being able to put capital to work in interesting opportunities,” Marty Kaplan, chief executive officer of the Chicago-based fund of hedge funds manager.

Kaplan said Mesirow may also deploy more capital to relative-value strategies such as capital structure arbitrage, which seeks to profit from mis-pricing of different securities sold by the same company. Mesirow has redeemed out of some strategies that take more directional views on the markets, such as long-biased equity and event-driven hedge funds that bet on corporate activities such as mergers and acquisitions. “As the situation in Europe deteriorates, right now you don’t see tons of corporate activities because confidence in board rooms has declined,” Kaplan said. Mesirow generally favors credit over equities strategies, said Kaplan, and prefers structured credit, which tends to be mortgage-backed, over corporate credit.(source: Bloomberg News)

Through the Lag - Europe's Leading Hedge Funds Add Investment Staff

2011-11-08T01:23:00.001Z

One of the ways of looking at the health of a hedge fund business is in staffing levels. Like many other businesses in finance hedge funds cut back on headcount in late 2008 and into 2009, and the cutbacks in London based hedge funds continued into 2010 (see this article for data on last year). The tables here are disaggregated and show that of the 48 largest indigenous hedge fund groups under the FSA's jurisdiction 28 added staff at the level of approved persons (APs) - those carrying out partner/director/AML and compliance/investment/CEO/COO/CFO type functions- over the period from August last year to August this year.

In aggregate the top 48 hedge fund managers (by assets) in London added 6% to professional numbers over the year to August. It was noted here a year ago that headcount, as captured by approved persons registered with the FSA, was still declining two years after the original Credit Crunch of this century. So at last in 2011 hedge funds have got far enough beyond the assets under management low of late 2009 to have sufficient confidence in the stability of their businesses to add to their staff numbers.

The hedge fund management groups that have shed the most staff are given in Table 2 below. Ignoring the firms that have reduced Approved Person headcount by one or two people, which may be just frictional changes or voluntary departures, many of the firms appearing at the lower end of the Table have undertaken significant change post the Credit Crunch.

The firm that has made the largest absolute number reduction in their professional staff is Brevan Howard, which has opened up a trading operation in Switzerland so that formerly London based staff can escape the increase in taxation in the UK. The exodus was led by CIO Alan Howard who has been followed by co-CEO Nagi Kawkabani to Geneva. Up to a hundred traders may be based in Geneva in time. However the opening of the Swiss office is not the only development. Brevan Howard has reconfigured the investment capabilities of the traders/managers employed. Specifically BH has cut back on allocations of capital to equity markets and funds resulting in staff departures, including a manager recruited specifically to launch an Indian equity fund, and the departure of Fabrizio Gallo who is returning to the sell-side. Gallo's BH Equity Strategies Fund has been closed. Instead the emphasis has been on adding to capabilities in commodities and macro trading. This repositioning has resulted in a net reduction in London-based investment professionals, but an expansion of the number of traders for the whole firm. Further Brevan Howard funds have produced good performance this year, and the firm is expected to continue to add teams in order to increase capacity to manage capital.

Corporate reorganisations have played a role in the appearance of other firms in Table 2. The Approved Person headcount given for *HSBC Halbis Capital Management was up to June 2011. At that point HSBC Halbis, the alternative asset management business of HSBC, was merged into HSBC Global Asset Management, and as ever in such a merger there was duplication of staff resulting in voluntary departures and redundancies.

Polygon Investment Partners has moved from a multi-strategy approach to running a series of funds dedicated to specific investment strategies. The flagship Global Opportunities Master Fund was finally closed earlier this year, after a two-year-plus wind up process, and the residual illiquid holdings are now in the Polygon Recovery Fund. The reduction in approved persons at Polygon took place in Aug-Sept 2010 as six people left in a short period, and head count has been stable amongst the professional staff since.

At Rubicon Fund Management the spat between returning head honcho Paul Brewer and the two men who deputised for him as CIO for two years, Timothy Attias and Santiago Alarco, has led to the change in numbers. The former co-CIOs left in January and April this year to set up their own firm Sata Partners.

Altima Partners had its peaks in assets in mid 2008 and its peak headcount in early 2009. Asset under management were $4bn three years ago and are now thought to be around $1.9bn. The count of APs has followed a similar path, though with a lag as one would expect. 38 staff members were registered with the FSA in January 2009, and the present number is 23, down from 28 in August of last year.

The third Table here ranks the firms amongst London's largest hedge fund managers that have added the most Approved Persons with the FSA over the period August 2010 to August 2011. In percentage terms Henderson's takeover of Gartmore has increased the Approved Persons count in a step-change by 45%, or 29 individuals. In hedge fund terms there was some overlap in the geographical areas invested in by the two companies when separate, but the styles used to run the European equity funds, for example, were very different. This has allowed Henderson to keep most of the Gartmore investment staff, though there are bound to be some who lose out in jockeying for position in such a takeover.

There are more themes at play in the Table listing those firms expanding than in the Table ranking those firms with declining investment and senior staff. Losses of staff numbers may be for idiosyncratic reasons, but firms add to their payroll when they have been growing their revenues for a while. In the hedge fund industry that growth in revenue can come from performance fees, based on better investment returns than a previous period, or, more likely, from higher assets under management (from subscriptions plus investment growth on existing assets). So the firms adding investment staff in 2011 would be expected to be those that have performed well enough to attract new assets.

The investment strategies that are represented in the list of expanding firms are clustered. The first cluster is in global macro/CTAs/commodities - Capula, Man AHL, BlueCrest, Armajaro and Clive Capital. There are some multi-strategy winners - Mako Investment Managers, Arrowgrass and CQS, but perhaps a less obvious winner is in credit management. The third cluster consists of Finisterre Capital, James Caird Asset Management, and Chenavari Financial Advisors/Credit Partners - all with a considerable credit aspect to their investments.

The increase in staff numbers at Europe's largest hedge fund groups over the year to August 2011 is far from dramatic at 6%. It does come after nearly three years of decline. The strategic thrust of the global hedge fund industry has been to expand in numbers in Asia and/or emerging markets rather than Europe (or even the United States). So it is good to observe some growth in headcount in the London-based part of the industry. The fact that the owners and managers of those businesses have shown caution in adding to their cost base via the headcount in the last year should serve the industry's employees well, as tricky times have returned from the middle of this year. Although there are the highest level of redemption notices for the year in place for the end of this quarter, I don't expect even a majority of them to be acted upon. And consequently I expect the employment levels in the London hedge fund industry in the first half of next year to be similar to those we are seeing now. Some stability would be be very welcome.

Macro Managers Coming Through at Last

2011-10-26T14:47:00.004+01:00

One of the disappoinments this year has been the performance of global macro managers. At the stage of half way through the year, it seemed that if a manager in this strategy had ridden the wave of QE2 inspired up-moves in equities and commodities then they gave it back by staying too long at the party, as the effects of monetary stimulus dissipated in May and from that month onwards. Those that lost a little in the 1Q may have made a bit back by mid-year, but there seemed to be too few managers that were able to ride markets in one direction and then the other with enough conviction or timing to make money across the whole of their books.

The pattern seemed to be if you made money early in the year you gave it back later. If a manager had a positive P&L in equities, they lost enough money in FX to be left around flat for the year. To be fair to the macro managers the market action this year, whether in fx or commodities or equities, has oftentimes not been in a pronounced trend for long. So it is that CTAs, the ultimate feeders off markets exhibiting trending behaviour, did not make good money until the last few months. Further, reversals have been sharp and volatility high - which makes it hard to hold onto gains even when they have been chiselled out of recalcitrant markets. The exceptions to the generality amongst global macro traders were those that tend to specialise in fixed income - the likes of Brevan Howard - for whom the trend was their friend for long enough for decent gains to be made by end of July.

One of things that surprised me at the half way stage in the year was that so few macro managers had made much at all. Some of these big-picture managers tend to have core fixed income books, and others express their views on Chinese growth in the fx markets or in commodities. But they all may be positioned long or short, and they decide their own timing and sizing. So there is a lot of scope for the universe of macro managers to have completely different directional bets in the same market. Those that don't do much in energy, might concentrate on time spreads in softs or run a big book in credit trading. The point is they need not have correlated returns at all - in fact logically the universe of global macro managers should always have the biggest dispersion of returns amongst hedge fund strategy groups, and most of the time it does. By happenstance, taking all these different views and putting on unrelated trades across a wide selection of markets, hardly any macro managers had made good returns by the end of June this year. However the market gyrations of August and September have allowed a different story to be told for the period since.

Only this week Luke Ellis of Man Group was commenting that there was a very wide dispersion of manager returns amongst hedge funds in August. In September there was an historic extreme of dispersion of returns amongst managers running hedge funds. So for observers of, or investors in, hedge funds the returns of August and September become much more about which managers you were in, rather than which strategies you were allocated to. And practically it means that index or industry level returns for hedge funds for those two months start to be quite unrepresentative. We are well used to seeing headlines about "Hedge funds failing to deliver this month/on the year to date" based on index level returns, and sometimes (more usefully in this context) about returns across a hedge fund database being "good" or "bad" or generally different from returns on the underlying markets at an asset class level.

When the YTD numbers are close to zero, the next data point has a big impact on YTD returns. That is what has happened to hedge fund returns this year, and for some global macro funds in particular. The tables shown here are from "Absolute Return" magazine and pick out amongst US-based managers the best returns produced last month. It is pleasing to see the marked presence of macro managers at the top of the rankings after the year they have had.

These are good returns of specific managers in the global macro investment strategy. However, today I see that The Greenwich Investable Hedge Fund Indices give the index level returns for macro managers as -0.79% for September and -3.72% for the year so far. My experience of dealing with investors in hedge funds is that they are looking at what their specific hedge fund managers have done for them. There will be nearly no one who has experienced a return from their macro managers of -3.72% in the year to date (for reasons of position sizing and the timing of subscriptions and redemptions, if nothing else). Given the extreme dispersion of returns in September, and that macro managers have the widest dispersion of returns amongst any hedge fund investment strategy I can confidently say that no-one except an index investor has actually got a return of -0.79% from their macro managers last month. The inference is that the returns of the last two months will tell investors a lot about the quality of manager selection amongst their advisors and consultants, and amongst funds of funds. And not just in global macro.

Additional:

(Dec 7th 2011) Reuters posted an article headed "Global macro hedge fund returns fail to impress". The full article is posted here. The article mentions Louis Bacon's Moore Global Investments, Fortress Investment Group, Tudor Investment Corporation, Caxton Associates and Brevan Howard.

Risk Managers are the Social Workers of Asset Management?

2011-10-10T16:04:00.001+01:00

Recent research has shown that in the UK 86% of youth workers/social workers time is spent in completing forms for reporting, and in attending meetings about clients and how the services are run. Only 14% of time is spent with clients.

This skewed sense of priorities came to mind when I read the 2011 Risk Management for Asset Management survey from Ernst & Young. In the survey there is a section about how risk managers in asset management companies use their time. The collated responses are in figure 1.

Figure 1. Relative priorities for risk management in terms of time

Source: Risk Management for Asset Management Ernst & Young Survey 2011 (page 35)

If this survey reflects the reality of how risk managers are spending their time risk monitoring takes up 10.8% and risk reporting takes up 9.7% of risk managers' time. I would like to think that the label "general risk management and client contact" applies to time spent with portfolio managers and analysts, but it is more likely to be with the Head of Equities or Chief Investment Officer, or in some client meetings.

Rather like IT spend in an asset management business, it seems that most of the budget (budget of the time in this case) is on the hygiene factors - the necessary operational systems (activities). At the moment there is lot of hygiene stuff to take care of in risk management in asset management businesses - tax related issues, KIIDs, increased burden of regulatory reporting and compliance, liquidity issues and not least counterparty issues.

But where is the main event at the moment? Is it not in the markets - the challenges to the business models of asset management businesses, real time stress tests of portfolio managers and their approaches to markets, the very viability of the financial sector in Europe?

What are risk managers spending time on?: regulatory affairs and contacts with regulators are taking up twice as much time as risk monitoring; country risk assessment is taking up less time than fraud risk.

In an inversion of the prevailing norm in social work, in a project in Swindon that works with chaotic families 60% of the budget is now going on selected face-to face service provision. This puts a bigger priority on the work that is the raison d'etre of the service, rather than its reporting processes and management.

A good risk manager can be a very positive influence on keeping the assets under management. The risk management function should help avoid blow-ups and gap risk, and assist finding useful hedges at the company level as well as the portfolio level. Good risk management is a long way from being just a quasi-compliance officer with a numerate degree. But the priorities and resources have to be agreed and in place for a fully realised risk management function to work as it can. Asset management companies should do a Swindon.

The Dangers of Mixing the Functions in a Hedge Fund Management Company

2011-10-05T11:16:00.000+01:00

In an in-depth due diligence questionnaire of a hedge fund manager there is often a question about the outside business interests of the principals. For an organisation with a broad team of decision makers managing investments this is less of a concern. To the extent that there is a single presiding talent who sets the tone and manages the largest allocation of capital, it is an issue if an individual has executive duties in other companies, or has too many non-executive directorships or Board positions. Think of SAC - if Steve Cohen more actively pursued his art interests at the expense of time at the firm would that that impact the returns produced by the whole firm? Undoubtedly, yes. But there are other ways in which hedge fund investment managers can be distracted from their main event.

I was reading about companies' management structure (link here, with thanks to author Daniel Dupree), perhaps a hangover from my Business Studies degree, and was reflecting on how the construct applied to the hedge fund business. The article was about levels of management:

Management levels within an organization exist to demarcate different roles within the organization or company, and to help establish a chain of command. Broadly, there are three main levels of management. You can think of the levels as a triangle, or pyramid. At the top level, there are fewer people, but they have more say in the overall direction of the company — they have more authority. This level is often called the administrative level. At the second level of management, you have those who have some authority over certain departments or projects. This is called the executory level, since those who populate it are involved in executing so that the aims of the organization are met. Finally, at the bottom of the pyramid, is the supervisory level. These are managers that have more direct contact with workers, and are mainly involved in encouraging performance, and monitoring employees.

The article then goes on to describe the scope of work in each level. Here are the descriptions of the top two levels:

Top Level: Administrative

The top level of management in most organizations is the ultimate authority. Administrative level managers can give authority to other managers in the organization, delegating to, or directly promoting, other managers. The top level of management consists of board of directors, top officers in the company, and directors in the company. Some of the functions of those at the top level of management include:

Setting out the goals, benchmarks and big picture for the organization.
Prepares policies for the organization, and sets forth consequences for their violation.
Promotes and appoints others to fulfill various roles in the company.
Coordinates activities for the whole organization, making sure that different departments are working in tandem to reach the organization’s goals.
Usually in charge of making public statements on behalf of the organization, as well as making appearances so that the community is aware of what the company is doing.
Directs broad changes in company direction.
Shows accountability to shareholders and other stakeholders in the company.
Ultimately responsible for the success or failure of the organization and its enterprises.

Those in the top level of management are often well-compensated for their efforts, due to the fact that, in theory, they have great responsibilities. It can be difficult to make it to the top level of management, since those positions are often scarce, and the competition for them is fierce. However, with hard work, good ideas, competence, and an ability to network, it is possible to reach the top level of management.

Middle Level: Executory

Depending on the size of the company or organization, middle management can be bigger or smaller. In some of the smaller organizations, the functions of the middle level and lower level of management are combined. However, in larger organizations, middle level management often requires additional divisions into senior and junior levels.

At this level, managers are in charge of branches or departments. Their job is to come up with sub-plans that contribute to the success of the company when meeting its goals. Middle managers are often involved in making sure that the steps to achieving the larger aims of the company are carried out. Some of the other duties that those at the executory level of management might be required to carry out include:

Training lower management, and training employees.
Coming up with incentives for employees and lower level managers.
Coordinating projects within the departments and branches.
Evaluating employee and lower manager performance.
At more senior positions in middle management, sometimes it is necessary to interact with the public, or issue statements.
Report to members of the top level of management. This might include in-person reports, or written reports and memos.
Enforce policies handed down from top management, and sometimes discipline lower level managers, or employees.

The owners of hedge fund businesses carry out all the tasks of Top Level Management as given above. However, it is quite usual for the largest shareholders of a hedge fund business to be carrying out the main activity of the company, that of carrying out research and making investment decisions. That is, the principals of a hedge fund management company carry out the Executory Level activity as well as fulfill the roles of those in the Administrative Level. Even where there is a separate CEO in a hedge fund, the CIO whose name is over the door is highly likely to be involved in decision-making related to how the business is run as well as how the investments are run.

Switching Modes

For many senior figures running portfolios this involves looking at a trading screen and taking company and investor meetings until the end of the trading day, and then switching modes to take Executive Committee meetings and Board Meetings into the early evening. If there are not those formal meetings there will be job interviews and looking through (management information system) reports on the business after the Bloomberg screen has gone dark.

I had a reminder of the duality of the lives of the senior executives running hedge fund companies when I bumped into one of them off Davies Street in Mayfair yesterday. In the course of our exchange he disclosed that the meetings and reading of documents associated with the expansion of his business was taking up some of his normal trading screen time. He said "I've cut back on the number of markets I'm actively tracking, and, to be honest, even in those I'm relying on what I researched earlier this year for the core of my views."

This chimed with what I had read about events at Touradji Capital Management this year. Paul Touradji is the former head of commodities trading at Tiger Management who set up his own firm in 2005. Just over two years later Touradji Capital was running $3.5bn in commodity related funds. But the progress of the firm has not been smooth since the Credit Crunch.

Returns from the funds were disappointing in the last two calendar years - up 4.5% in 2009 and then up 2% in 2010 against a background of bull market conditions in commodities. Investor redemptions took capital down to below $2bn this year. The senior management team has not been stable. Gil Caffrey came on board from FrontPoint Partners to be CEO at Touradji Capital Management, only to decide last year to walk across the hall back to Tiger Management. Julian Robertson's Tiger Management shares office space with Touradji Capital on Park Avenue, New York. Sang Lee was brought in as President of Touradji Capital in October 2010 as part of a handover of day-to-day management of the firm from Caffrey. But that transition was not successful.

It was announced last month that President and Chief Operating Officer Sang Lee and CFO Tom Dwan will leave the firm, and a search is on for high calibre replacements. In a letter to his investors Paul Touradji wrote "Simply put, the daily operation of the firm must go from being a major time and energy drain on me to an integral support function for our entire team, allowing us to concentrate our full attention on investment performance." The flagship fund of Touradji Capital Management was down 17% in the first 8 months of the year.

Touradji Capital Management is not a start up or a very small hedge fund management company. But events there illustrate that non-investment issues can be a drain on the capabilities of professional investment staff at the very top level of hedge fund companies. Even very capable people have to be careful about how they allocated their time and intellectual bandwidth. To consume the creative thinking time of a well-paid investment professional at the top of his game with the banalities of failed trades and who is doing the cash reconciliations this week is a failure of management resource and structure.

Potential investors in hedge funds sometimes go to great lengths in due diligence to fully appreciate the state of play at a hedge fund management company. I heard a comment this week that there is something of an arms race in due diligence processes amongst funds of hedge fund companies, as they try to differentiate themselves on something other than results. But there is a risk in a small company that the scarce resource of management time can move from the mission critical (investing) to the necessary (operations and company oversight) and that is something of which a prudent investor should be aware.

Hedge Fund Credit & Risk

2011-09-28T13:15:00.001+01:00

A couple of weeks back I joined in a presentation put on by PRMIA (The Professional Risk Managers International Association) at Imperial College, London. The sessions were on hedge funds and credit risk, and so I tapped into my experience as a risk manager in a single manager hedge fund and what I observed during the Credit Crunch of 2008/9 and explored the contrast in credit conditions for hedge funds between the period before and the period after the Credit Crunch. These are the slides I used:

Book Review for "The Inner Voice of Trading"

2011-09-27T21:18:00.002+01:00

A successful trader or investor in financial markets succeeds through a combination of factors. There is the "what they know" part; there is the trading format the trader or investors uses; and there is the less well explored element in the mix - the "other" of the trader besides technical/factual knowledge. Michael Martin's new book "The Inner Voice of Trading" (FT Press) is an exposition on this last element.

Michael Martin has been a market professional on the sell-side, a trader of his own account in stocks and commodities, and someone who has been a trader trainer for a living. He has also interviewed great traders seeking insights into the ways of working that made them great (see his website www.martinkronicle.com). This background makes him well equipped to explore what seems to be the hardest part of trading in which to excel.

Financial markets are full of smart people with MBAs, CFA qualifications, and, increasingly, PhD's.Quite sophisticated trading systems can be bought off the shelf for really very little outlay (hundreds of dollars rather than thousands). Logically there could be many more successful traders than there are. So there is an argument to be made that this last element of trading - the soft factors, and focusing on knowing yourself as an investor/trader - is one that is under explored and developed. This is the gap this book is seeking to fill.

Martin's progress through the psychology of successful trading is reinforced by evidence and quotations from prominent traders. This gives the thrust of the book credibility if not authority. In an era of the "me first" society his focus on development of the individual's own trading culture should find appeal, but though this is part self-help book, be aware that this not a step one-step two guide to to how to do it. The book has well-observed pointers but is not a manual for trading.

That written, Michael Martin's book will have resonance for those already operating in financial markets on the buy-side, and will be extremely helpful to the neophyte trader. This is a welcome addition to the oeuvre of investment books, and its' focus makes it a good companion text for those who like the "Market Wizards" series and their ilk.

For other views of this title see the Amazon page for it.

UK Focused Hedge Funds to Benefit from More QE and More Devaluation

2011-09-02T15:53:00.003+01:00

This short opinion piece from SVM's Colin McLean was so brief and on-the-money I thought I should share it. The third paragraph in particular is worth absorbing.

"The summer stockmarket sell-off caught most investors by surprise. Expectations changed sharply as a good company reporting season in July gave way to a vacuum in US and EU political leadership in August. There are now mixed signals on the global economy, pointing to new risks. But the crisis is throwing up new opportunities as well as dangers.

While some data is contradictory, evidence is mounting that global growth will disappoint. Expectations are changing most rapidly in Europe, but in all regions scope for further effective stimulation is limited. Governments cannot re-run the unprecedented stimulation of 2009.

However, the UK can still do more than most to tackle the slowdown. It has currency flexibility and an independent monetary policy, allowing it to move more rapidly than the US or Europe. Before the year end, another round of quantitative easing seems likely in the UK, and a further devaluation of the Pound by around 10% is possible. This will immediately benefit Britain’s exporters and other global businesses listed in London. Stimulation would be a catalyst for money on the sidelines to buy shares. Hedge funds generally have had poor returns this year and will be eager for a rally. Portfolios need to be positioned ahead of this."

Net market exposures are currently low, and cash levels very high amongst hedge funds. There is a potential for a partial re-run of the equity rally provoked by the last round of Q.E., though markets never repeat exactly.

Chart of the Day - Extremely High Correlation of Stocks - Implications for Hedge Funds

2011-08-26T14:52:00.002+01:00

I'm doing some work on risk measurement/management at a hedge fund management company. The investment strategy of the hedge fund is long/short equity. Most of the work revolves around measurements at the portfolio level, and the aim of measuring and controlling risk is to produce steady returns for investors. This is only possible on a sustainable basis with a diversified portfolio, unless the hit-rate is unusually high. Whilst I have met managers with very concentrated portfolios based on very stringent selection criteria, and who have very high career hit-rates (as high as over 90% in one case), most mangers (probably more than the 80:20 rule would suggest) run portfolios diversified by stock, sector and to some extent theme.

Effective risk management is partly about being aware what has a high probability of working and when. One of the lessons of the Credit Crunch for many in hedge fund land is that there are market circumstances in which the previously assumed risk controls will not work. That is, the manager has a series of limits and stops and processes which in combination will produce the desired outcomes for most market conditions. The rub, as revealed in 2008-9, is in the conditional "most". Managers have to be aware of in what market circumstances their approach to markets will not work.

For most equity long/short managers most of the time the key decision variables at the portfolio level are about managing the net exposures to market, and specifically about managing the net beta-adjusted exposure to the market. There is a sub-set of equity managers for whom this is not true - those which have a limit on their net exposure to markets, and are structurally close to net neutral, say a band of 0-20% net long. Often the latter funds are quantitatively-driven equity long/short funds, but some discretionary managers choose to be close to net neutral. For these net-constrained funds returns have to come from stock selection to a much greater extent than funds with wider investment powers. The corollary is often a larger gross exposure to markets - consistent with the formulation of information ratios of managers. Typically, funds with a small net exposure limit target lower absolute returns, and implicitly rank risk-adjusted returns as a higher goal than absolute returns.

The majority of managers in equity long/short try to use the additional degrees of freedom they have in balance sheet disposition to produce higher absolute returns (than a net-neutral manager) though nearly always with higher volatility of returns. The tactical shape of the fund should be a function of two things: the market regime and the opportunity set for the particular investment style of the manager. There is a considerable range of understanding amongst managers of the necessity of taking these two dimensions into account in setting the net exposure of equity hedge funds. The best managers are good at both, but the majority of equity hedge fund managers are not. Yes, the majority.

The successful shaping of the hedge fund balance sheet requires two attributes in the manager: an ability to read the market regime in multi-dimensions, and a high degree of self knowledge about the applicability (and effectiveness) of their investment processes. Around the time of the Tech Bubble the first required ability was demonstrated a lot by equity hedge fund managers. The monetary stimulus provided by Greenspan on fears of the Millennium bug was read by managers as a bull market condition green light, and most managers were very net long in 1999, and investors were gorged on the excellent returns produced. The reverse happened from March 2000 onwards. By the 3Q 2000 many equity hedge funds were net short on a tactical basis, i.e . the managers jobbed from the short side. From 2003 to mid 2008 a net long bias and a buy-the-dips mentality were positive attributes for managers. Over the same period many new hedge fund managers joined the industry, and several big names closed down, citing the lack of shorting opportunities as a reason.

So coming into the Credit Crunch phase of 2008 only a minority of equity hedge fund managers expressed an ability to read the market regime by going net neutral or net short. A majority of managers had never been net short to that point, and many did not have that available as a choice because of their offering memoranda, or because the operational limits they gave themselves precluded it.

Current market conditions have echoes of 2008-9: large daily declines in equity prices, volatility and rising fear gauges in the price of gold and the cost of interbank borrowing. These are difficult conditions in which to manage an equity hedge fund. Quite how difficult is in part reflected in today's chart of the day. Every manager can tell you about the level of market volatility reflected in the Vix Index. This captures the current level of volatility in the market on a traded basis. The actual volatility experienced in the market is lower than the traded level, though intra-day measured volatility can be higher than that indicated by the Vix.

All equity hedge fund managers are aware of how volatility shifts impact their style because they can see it in the daily P&L changes per position, and the same at the portfolio level, and they are aware of the Vix. Those managers who take risk measurement more seriously will be aware of the Value-at-Risk of their portfolios. The same portfolio will have a different measured risk dependent on market conditions - when markets are more volatile measured risk goes up for the same portfolio. What is less well explored is the other element that feeds into the risk measure VaR, that of correlation.

The inter-relatedness of positions has an impact on measured risk. The more related the positions the less diversification there is in a portfolio. Consequently managers structurally build diversification into their portfolios by having limits on sectors/industries/macro-related themes as well as limits to specific stock risk by constraining holding size. But correlation is not stable. Cross-sectional correlation varies through time. In up-trending markets (scenario 1) volatility drops and stocks tend to become less correlated. For sideways moving markets (scenario 2) two stocks in the same sector could quite feasibly act differently - one going up and the other staying the same price, or even falling. Scenario 1 is better for producing returns from net market exposure, and scenario 2 is a richer market opportunity for returns purely from idiosyncratic stock risk (selection).

However when markets fall for a period volatility rises and correlation increases. The correlation coefficients of stocks' betas go up - the market component of stock price changes goes up, and the sector effect increases and the idiosyncratic component of stock price changes declines. The chart of the day below illustrates that we are at an extreme for measured correlation amongst S&P500 constituents.

In such a market environment portfolio returns become a product of the net market exposure, driven by the weighted average of the portfolio betas. The extreme case illustrates the point - bank shares and commodity stocks have had the highest betas in the market for some years now. The return to the net exposure to these two sectors plausibly could have been the largest component of the return of individual equity hedge funds over the last three years. For net neutral equity hedge funds the net exposure decision on these two sectors over the last three years could have even been the decision that determined return outcomes.

For market conditions with high correlation between stocks it is just about impossible to drive returns from stock selection (idiosyncratic risk) alone. This has recently been explicitly recognised by one management team - Ralph Jainz and Jonathan Sharpe of Ratio Asset Management wrote to their investors on closing their European equity hedge fund this month that "this year stock selection has not proved profitable." History suggests that it is difficult for diversified net neutral funds to make money when there is high correlation between stocks, and only managers who are adept at shaping the balance sheet of their hedge funds will actually make money, as opposed to defending their capital.

Given that nowadays few managers can demonstrate an ability to read the market regime in multi-dimensions, and have a high degree of self knowledge about the applicability of their investment processes, I expect negative returns from the strategy for the current market. What is particularly disappointing is that the number of managers who can show they truly learned lessons from 2008-9, and can make money now, are so few. Maybe investors have to exhort their managers to take some off some of the net exposure restrictions - or do investors doubt that their managers have sufficient skills to handle wider investment powers?

What are Hedge Fund Managers made of?

2011-08-10T11:53:00.001+01:00

What are HEDGE FUND MANAGERS made of?

     40% Work Rate
     15% Ambition
     15% Talent
     12% Hubris
     10% Entrepreneurialism
       8% Reactiveness

What are FUNDS OF HEDGE FUND MANAGERS made of?

     35% Process
     20% Marketing
     20% Database and library
     15% Understanding
       5% Structure
       3% Risk measurement
       2% Promises

Add your own version and responses using the comments function below.

The Hedge Fund Job Interview

2011-08-04T12:34:00.000+01:00

I know the readership of this website includes partners in hedge fund management companies, but it has also attracted some people who are both relatively new to hedge funds and some looking to get into the hedge fund industry. So this article should work for both constituencies.

I came across some interview questions used by Lex Van Dam, who may be widely known for the tv programme "Million Dollar Trader", but who now runs his own small hedge fund company called Hampstead Capital. He was formerly a trader at Goldman Sachs and GLG Partners. Lex has been described as tough or brusque. When I have dealt with him he has been direct and commercial but polite. The directness of the questions are what an interviewee at a hedge fund may face because the people who run them often are strict over use of their time, as is Lex himself. The questions are biased towards hiring a trader for a hedge fund.

a) To assess energy, drive, initiative
1.Why are you here?
2. How did you prepare for this interview?
3. What was on the front page of the FT today?

b) To assess personal growth and performance over time
4. Tell me about your job?
5. What could make you fail here?

c) To assess past accomplishments
6. What was the biggest success you had over the last 12 months?
7. What is the most pressure you have ever been under?

d) To assess problem solving skills
8 Is your intelligence above average? What percentage of people have above average intelligence?
9. Does the quality of your decision making improve under pressure?
10. How many buses are there in London?
11. What is 32*32? How confident are you about that answer?
12. How many degrees between the hands on the clock at 3.15?

e) To assess overall talent, technical competency and potential
13. What makes you a good trader?
14. What is the most money you have ever lost?

f) To assess management and organizational ability
15. If I gave you £100,000 what would you do with it?
16. What is the most difficult decision you ever had to make?

g) To assess team leadership and the ability to motivate others
17. Do you react better to compliments or criticism?
18. How do you deal with authority when you perceive them to be wrong?

h) To assess character - values, commitment, goals
19. What would you wear to the office?
20. How are you with money? Are you a big spender? Are you in debt?
21. Would you screw someone over to get ahead?

i) To assess personality and cultural fit
22. How do you measure success in your life?
23. Why should we hire you and not someone else?
24. If things go wrong do you tend to blame other people or take responsibility yourself?
25. How do you think the interview went? If you were me would you hire you?

Please feel free to add some questions of your own using the comments button below. The questions given here were disseminated on E-Financial News.

Hedge Fund Returns for 2011

2011-08-01T23:14:00.000+01:00

A poll was conducted on this website recently asking this question:

"In 2010 the year was rescued in performance terms by the huge injection of QE2. So the outcome was a reasonable year. Is there a Second Act to rescue this year? What do you think hedge fund returns will be for the whole of 2011?"

Most respondents were still looking for positive returns from hedge funds in 2011 - only one-in-six who took part in the poll were looking for flat or negative returns for the year.

Nearly three quarters of the votes were cast for either +2% or +5% returns, and only 8% of participants were looking for 7% or better returns for 2011 from hedge funds. If the outcome was in the range suggested investors in hedge funds would probably be satisfied, with a couple of conditions. To give credibility to 5% returns from hedge funds, equity markets would have to be flat (or down on the year), and inflation would have to moderate between now and year end. How plausible are those conditions?

Truly Knowing the Family Office Client is Hedge Fund Marketers' Most Important Challenge Now

2011-07-22T16:37:00.005+01:00

Family offices are viewed as having a series of advantages as investors in hedge funds:

Family offices tend to have long-term investment horizons.
They tend to want to live with decisions for some time – as a source of "sticky money" they won't flip a multi-year investment proposition after a couple of bad quarters.
The investment decision making is often quicker than either funds of hedge funds or institutional investors that use consultants to select hedge funds.
Due diligence of family offices is less invasive and time consuming than for investing institutions.
They typically require less client servicing resource than other investors in hedge funds.
They tend to have less restricted selection criteria than institution al investors – family offices can invest in niche strategies, emerging managers and small funds.

Rothstein Kass, the US based professional services firm, last month produced some timely research from talking to 67 family offices in the United States and 84 from outside the U.S. The research indicates that roughly 85% of single-family offices currently invest in hedge funds, and nearly half invest in private equity vehicles. Of those family offices that have existing hedge fund investments (and only they were invited to participate in the survey) nearly 90% of them (88.7%) considered themselves highly likely to add to their investments in hedge funds. Whilst there was no timeframe qualification posed in the question, this means that family offices are probably the most likely group to increase hedge fund commitments of all hedge fund investor types (HNWIs, endowments, pension schemes, insurance companies and charities).

The willingness to commit further capital to hedge funds would put family offices as the investor type with the highest proportional commitment to hedge funds of all. Each year The Institute for Private Investors surveys its 1100 ultra high net worth members to ascertain performance obtained and attitudes to and exposure to the various investment strategies and asset classes. The Family Performance Survey of 2010 (published by Campden Media) gives the average asset allocation across all family offices in this predominantly (89%) American population. As at the end of December 2010 the average exposure to hedge funds and funds of funds of the respondents was 19% of the total assets. This level was similar to that reflected in the 2009 survey, but remains at the top of the range of exposure compared to pension plans, insurers and some endowments. So family offices are already well committed to hedge funds, and have more exposure than others, even before they make further commitments.

Over the years studying family offices, Rothstein Kass has developed a number of different segmentation criteria. One very powerful segmentation model is based on psychographics and distinguishes between family offices that are Wealth Creators and those that are Wealth Preservers. Wealth Creators are charged with enhancing or increasing the fortunes of the underlying family. In contrast, Wealth Preservers are focused on ensuring the safeguarding of the underlying family's wealth. In this study the greater majority of the single-family offices can be classified as Wealth Creators, as shown in Graphic 1. The identification of the correct segment for the family office should be very significant for those marketing hedge funds as it feeds into general risk appetite for hedge funds and into the appetite for specific hedge fund investment strategies (Table 1).

Graphic 1. Wealth Creators (70.9%) versus Wealth Preservers (29.1%) amongst Family Offices

Source: Rothstein Kass, where N=151 Single-Family Offices

This is how Cheryl B. Rogers, Senior Vice President at Forbes Private Capital Partners (which was involved in the research), has experienced these characterisations in practice: "Many single-family offices pursue investment diversification strategies that blend aspects of both wealth creation and wealth preservation. However, most are clearly weighted toward one overarching philosophy that is often dictated by individual family circumstances. At this stage the alternative investment is sufficiently diverse to offer suitable investment options for investors of nearly all risk tolerances. Wealthy clients nearing retirement, for example, are more likely to pursue a wealth preservation strategy to guard against fluctuations that would negatively impact their lifestyle or restrict the generational transfer of wealth. They tend to gravitate toward alternative products that offer annuity-like returns or hedge more aggressive positions."

The survey evidence (shown in graphic 2) is that the family offices with a wealth creation investment ethos are more likely to add to their hedge fund investments than the wealth preservers. Part of the motivation for this was expressed by Bruce H. Rogers, Chief Brand Officer and Managing Director at Forbes Insights, one of the research organisers. He said "many high net-worth families are seeking to recoup wealth eroded during recent periods of market weakness. These "wealth creation" investors tend to be relatively less risk averse than those pursuing wealth preservation strategies."

Graphic 2. Most of Respondents Highly Likely to Add to Hedge Fund Investments are Wealth Creators (77.6%)

Source: Rothstein Kass, where N=134 Single-Family Offices, Wealth Preservers 22.4%

When it comes to investment strategies engaged in by hedge funds, the preferences of family office investment directors are like those of hedge fund investors generally in some ways, but not in others. Table 1 shows the expressed preferences by strategy of the family offices which were highly likely to add to their hedge fund investments. Like the respondents to the Deutsche Bank Alternative Investment Survey of March this year it is most common (53% of respondents) to state a preference of allocating new money to long/short equity funds, and it is similarly common (48%) for family offices to express a preference for distressed funds. The bias of family offices towards distressed funds was not shared by the broader range of participants to the DB survey, which had distressed funds in the lower half of the preferences ranking. Emerging markets, global macro and event driven funds are all a lot less popular as recipients of fresh investment capital amongst family offices than amongst the broader range of hedge fund investors.

Table1.

Source: Rothstein Kass

I noted at the start of this article that family offices have a series of perceived advantages as investors in hedge funds. Then I observed that family offices are probably the sort of investor most likely to be adding to their hedge fund investments in the medium term. Putting these concepts together will have some consequences for those who seek family offices as potential clients: the Rothstein Kass research notes that the competition for the investment dollars of family offices will probably grow geometrically. To succeed in this market hedge funds may have to raise their game in the marketing/sales process.

Rothstein Kass have a view on this – "investment managers will need to be highly consultative if they are to succeed in generating capital flows from single-family offices." They describe the consultative approach as having three basic components. Central to this approach is profiling the single-family offices to understand: (1) their investment orientation, (2) the roles, responsibilities and professional objectives of the Executive Directors, and (3) the professional ecosystem of each single-family office. The other basic components of the consultative approach are "creating customized explanations of offerings" and "continuously managing the relationship."

Here is the meat. The authors of the research say that "when it comes to the consultative process, we regularly find the greatest weakness among (provider) financial firms is in their profiling of family offices." They continue that "investment managers are well served by maintaining an open and ongoing dialogue with family office investors to ensure ongoing alignment of objectives and risk tolerances."

While it may be a regulatory requirement to "know your customer", there is a genuine commercial angle here. Successful selling to family offices is much more likely to occur where the selling hedge fund has made the effort to know how the family office actually works, and what the risk tolerances are (wealth creator or wealth preserver), and puts resource into developing a relationship with the key decision makers that goes beyond the immediate need to sell some product. This may be the hedge fund marketers (internal or third party) most important task in the immediate environment.

Battle of the Quants London 2011

2011-06-17T16:39:00.022+01:00

This year I have experienced two rounds of the Battle of the Quants. The first was the edition of the radio show "The Naked Short Club" broadcast on Monday of this week.

Host Dr.Stu bursts into the studio with his posse, and sets about arranging the guests

The show featured a line up of speakers that were going to feature at the conference later in the week:

Dr. Marco Fasoli- Managing Partner, Titian Global;
Robert Passarella- MD, Dow Jones;
Con Keating*- European Federation of Financial Analysts;
Simon Kerr- Enhance Consulting/Hedge Fund Journal;
Bartt Kellermann- Organiser, Battle of the Quants

There was some great too-ing and fro-ing between guests as topics were debated - both sides seemingly with conviction. It was the best edition of the show I have been on myself.

Bartt Kellerman, Rob Passarella, and guest announcer
and "Dazed & Confused" Editor Rod Stanley squeeze into the studio.

Rod Stanley reads his script, while Dr. Marco Fasoli
and Con Keating prepare to respond to a tough question.

If you would like to listen to this show you can hear it via this download link.

My second round of Battle of the Quants was the full conference held on Thursday the 16th June, at which the Keynote Speaker was Dr.Paul Wilmott, Ph.D, publisher of the eponymous quant magazine and website. His professional background includes trading volatility at a hedge fund, so he has seen and applied quantitative methods as used in finance in practice as well as in theory. He addressed his audience of quants and investors in quant funds on some of the problems of doing this. He cited calibration and market completeness as particular problems.

An example of calibration is the the estimation of volatility for the pricing of derivatives. Models have to be fit for purpose and reflect the world as is. According to Paul Wilmott re-calibration of a model by changing parameters is a form of model risk. He was aghast to inform his audience that regulators of financial activity like to see re-calibration of banks' models used to price products and estimate risk, sometimes to the point of enforcing re-calibration.

Dr.Wilmott sees the concept of market completeness as somewhat dangerous. Markets are incomplete in reality - even fast moving markets with very large volumes have gaps in price, as fx markets show over and over, and the flash crash in the S&P showed last year. The quant maven asked rhetorically "Why then is the idea of market completeness popular?" It is because it enables market participants to use ideas of risk neutrality and a certain type of mathematics. The danger is in the fact that risk neutrality in a state of market completeness is a special circumstance, and not the governing mode of markets.

The Keynote Speaker had a theory about quantitative techniques as used in finance - that most people who use them don't much go beyond the tools of second year undergraduate mathematics. In particular, Paul Wilmott claimed that knowledge of fluid dynamics and the maths of mechanics would replicate how most people in the market address some very complex real world topics in finance. He gave an example of coming across a group in a financial institution attempting to model hurricane activity who assumed a log-normal distribution.

My own take on this is that the application of quantitative techniques to markets is no different than, say, a fundamentally driven approach: there are a range of abilities and resources being applied within the broad category. So for those that analyse industries and companies there will be some who rely only on street research; there will be those who carry out there own research, and those that employ expert networks. The depth of knowledge and understanding of a company or industry will vary a lot, and (relative) bet size should vary with the size of the edge (and risk/reward).

A good example of how different market participants cope with the shortcomings of modelling is in the pricing of traded options. All market participants (apart from the retail punters) are aware that the distribution of market returns is not log-normal. If you like, if you have a Bloomberg screen you will know that there is a smile in option pricing in OTM puts. If you are running money at a long only institution and use options you will be aware that those OTM puts are not necessarily expensive, but reflect a higher probability of a large fall in the underlying asset than is reflected in a log-normal distribution of returns. For the long only investor, who would hedge or take risk using options over a period of weeks-to-months, the assumption of the distribution of returns is flawed but sufficient for the purpose. For a market maker, who is modelling a three dimensional volatility surface and managing risk through constructing a risk book with a positive gamma, and has a time frame of intra-day and over-night risk, the assumption of log-normal returns is not adequate. No market maker uses pricing software that assumes that naive distribution of returns. So the different utility functions of the types of market participants will feed into the willingness to operate with a pricing model that is known to have shortcomings.

*Con Keating told a good story off-air about getting through US Immigration quite a few years ago. Although UK passport holders benefited from a visa waiver scheme when travelling to the US, Brits still had to fill in the customs form. Keating completed his and waited-in-line to be seen by the customs/immigration officer. Many will know that the US immigration procedures for an alien can be tough - they don't hesitate in sending visitors back on the next flight.

Finally Con Keating got over the yellow line and handed over his papers; the officer raised an eyebrow on reviewing them: "Mr. Keating you know we take immigration matters very seriously here. You don't appear to be doing the same: it says here under 'currency and valuable material' being brought into the United States that you are bringing in $223million. Is that correct?"

Keating confirmed that it was, and the officer went to have a consultation with his superior, eventually deciding that it was okay for the would-be visitor to enter the United States. Keating was much relieved as although he was there for a series of important business meetings he also had the job of delivering $223m of bearer bonds on behalf of his employers!

Out of the Box - Graphic of the Day – Why Hedge Funds Will Continue to Grow

2011-06-08T15:59:00.007+01:00

One of the advantages of looking at the activities of institutional investors is that their behaviour follows decision-making which stands for years at a time. The Investment Committee of a pension plan changes the strategic asset allocation say every 5 or more years. There may be a decision made to have 25% of plan assets in domestic equities with a tactical band of 20-30%, which allows for variation on an annual basis away from the central tendency of 25%. But for most of the time over six or seven years the plan assets will be around 25% in domestic equities from that point onwards, after a period of implementation.

The implementation of the change in asset mix will often take place over a year or more as mandates are changed, contractual notice is given to the money managers with the mandates, and the underlying assets are bought and sold. Allocations to domestic equity have tended to shrink over recent years, so the process might involve a plan sponsor giving six month notice to a Trust Bank that their mandate will halve in size, and then, in six months time the bank will liquidate a portion of their large cap mutual fund and transfer the cash to the pension plan's administrators.

The reverse process is expected to happen for hedge fund allocations over the next few years if the survey of investment consultants by Casey Quirk and eVestment Alliance is to be believed. The survey*, conducted in Dec 2010 and January 2011, asked investment consultants to forecast investment preferences and buying behaviour among North American institutional investors during 2011. One of the key trends that Casey Quirk identified was "The increasing role of heretofore "alternative" investments—hedge funds, private equity and real estate—which are emerging as the centerpiece of active asset management moving forward."

This trend in the use of alternatives reflect the new frameworks with which institutional investors and their consultants are building portfolios, with exposure defined less by product packaging or home bias, and more by the specific contributions investments make toward overall objectives. The framework is part of the new emerging paradigm for asset allocation amongst investing institutions in North America, shown in the Graphic of the Day below, and which will reinforce hedge fund growth.

Graphic of the Day - Hedge Funds Break out of The Box
The Emerging Institutional Investment Framework

Source: Casey Quirk (Note Not to Scale)

The key point in this is that the way institutional investors see how they can use hedge funds is changing. It was hedge funds as part of an alternatives category - in a segmented ghetto by risk/return. This is changing towards hedge funds as sources of alpha within broader asset categories. Hedge funds are breaking out of the box!

Putting this framework, and the consequent asset shifts, into practise over coming years will not benefit all asset management businesses. Amongst the attributes of the winning asset management firms, according to Casey Quirk and eVestment Alliance, will be

Managers offering non-correlated investments.
Firms offering both "traditional" and "alternative" investments will stand the best chance of providing institutional clients with a total portfolio solution.
Product development and innovation will remain critical competitive differentiators.

The survey collators go on to turn their gathered insights into a product opportunity map – showing where demand for product will be strongest.

2011 Product Opportunity Map

Source: Casey Quirk, eVestment Alliance

It is important to understand that the product opportunity map compares expected search activity for the upcoming year relative to forecast from the previous year. What is clear is that consultants continue to believe that longer-term trends in search activity favour hedge funds, funds of hedge funds, and non-U.S. equities. However, there is a perceived shift in the demand for funds of hedge funds:

"Consultants focused on larger investors, as well as those focused on non-profit funds, expect more searches for direct investments in hedge funds than they did in 2010. This reflects three realities.

First, most North American institutional investors selected a core fund of hedge funds in recent years, and few are yet convinced they need a change.
Second, and more importantly, larger investors now seek more specialized FOHF strategies in place of, or in addition to, a diversified FOHF mandate. This challenges many FOHF vendors who do not offer a focused product.
Finally, larger institutional investors—particularly well-funded non-profit funds—still seek to avoid higher fees and pooled vehicles offered by FOHFs.

FOHFs remain core investment vehicles among smaller pension plans who lack resources to select or access direct hedge fund investments. Additionally, investors increasingly are using outsourcing firms to provide exposure to a portfolio of hedge funds."

The trends identified by the survey authors will likely persist for some years, as allocations in pension plans change slowly, and allocations to hedge funds are going up – doubling in some forecasts. So hedge fund capital flows should be positive at the industry level on a multi-year outlook. There is still a role for funds of hedge funds serving American institutions, and indeed there should be growth in assets this year and next for funds of hedge funds as a whole. But to benefit from those allocations funds of hedge fund businesses are going to have to be in the top quintile of performance ranking over 5 years, and in 2008 specifically, or have a very good specialised product (by geography or investment strategy) to offer.

*This year, 55 investment consultants, representing an aggregate $10.4 trillion of assets under advisement participated in the survey.

Seth Klarman of the Baupost Group - his top investment books

2011-06-02T12:06:00.001+01:00

When I put my top investment books on this webpage (see lh margin) the choices inevitably reflected the style of investment I use myself. The books which enhanced that style rise to the top of the list, as well as those that are well written or well structured.

Similarly, looking at Seth Klarman's recommended reading list (given at the CFA conference last year), the choices reflect his value based style of investment:

Benjamin Graham's "The Intelligent Investor"

Joel Greenblatt's "You Can Be A Stock Market Genius"

Martin Whitman's "The Aggressive Conservative Investor"

Michael Lewis' "Moneyball: The Art of Winning an Unfair Game"

Andrew Ross Sorkin’s "Too Big to Fail"

Klarman also recommends the work of a couple of authors: Jim Grant and Roger Lowenstein.

You will know Jim Grant from Grant’s Interest Rate Observer. So you probably know how well he writes. His book titles are: "Bernard M. Baruch: "The Adventures of a Wall Street Legend" (Simon & Schuster, 1983), "Money of the Mind" (Farrar, Straus & Giroux, 1992), "Minding Mr. Market" (Farrar, Straus & Giroux, 1993), "The Trouble with Prosperity" (Times Books, 1996) and "Mr. Market Miscalculates" (Axios Press, 2008).

Roger Lowenstein I know best from his book on LTCM. These are some of his titles: "Buffett: The Making of an American Capitalist" (Random House,1995), "When Genius Failed: The Rise and Fall of Long-Term Capital Management" (Random House 2000), "Origins of the Crash: The Great Bubble and Its Undoing" (Penguin Press, 2004), "The End of Wall Street" (Penguin Press, 2010).

Hedge Fund Radio on the 6th June

2011-06-01T15:40:00.001+01:00

Make sure you listen out for the Monday, June 6th edition of the Sony Awards-nominated N@ked Short Club on Resonance FM [104.4FM within London/online worldwide on the internet here]: 1 hour of loose talk about hedge funds and the state of the world, plus sweet prose and heady music...No promotional agenda, no commercial intent...just Ponzi Bier and Pure Alpha both on tap.

Host, Dr. Stu will help callers to the Emergency Hedge Fund Helpline (1-800-DISTRESSED) to re-evaluate their Inner Mark to Market, with expert guests: David Miller, CIO- Cheviot; Mike Gasior- CEO, AFS (astrally projected from the US); Philippa Malmgren, President- Principalis; Simon Kerr- Enhance Consulting/Hedge Fund Journal; Stephen Pope, Managing Partner- Spotlight; plus City headhunteress/ writer, Sarah Dudney & the Galleon-smooth Anna Delaney.

The show is broadcast between 9-10pm/ 21.00-22.00 hrs., London time.

And you can listen to a podcast of the show at (for a period):

http://dl.dropbox.com/u/1442785/The_Naked_Short_Club_6th_June_2011%20.mp3

How Hedge Funds Can React to the Insider Trading Enforcement Initatives of the US Govt

2011-05-25T11:16:00.000+01:00

According to law firm Baker & McKenzie, the recent conviction of Galleon Group's Raj Rajaratnam serves as a further alert to hedge funds of the heightened risks posed by the US government’s sweeping insider trading enforcement initiative and the need to mitigate those risks proactively. In a client alert partner Marc Litt gave six things you need to know about the government focus on insider trading, and proffered some suggestions as to how hedge fund management businesses should respond. As a significant part of the readership of this website is hedge fund managers based in the United States I thought I would share the most relevant parts of the client alert.

Six Things You Need To Know

Among the lessons to be drawn from the government’s ongoing focus on insider trading and the conviction of Rajaratnam are the following:

1. More to come. Although the Rajaratnam conviction marks the highwater mark, to date, of the government’s crackdown on insider trading, it does not mark the end of that effort; there is more to come.

2. Aggressive enforcement tactics. Prosecutors will continue to use aggressive enforcement tactics, including wiretaps, search warrants and recordings made by cooperators, to build criminal insider trading cases.

3. Not just criminal enforcement. Where there is insufficient evidence to bring criminal prosecutions, regulators may instead seek sanctions through civil and administrative proceedings.

4. Reputational damage. Mere association with insider trading allegations visits severe reputational damage on the institutions involved and, especially in the case of hedge funds, can result in dissolution.

5. Compliance counts. The best way to avoid being swept into the enforcement net is to develop a rigorous insider trading compliance program, including a zero tolerance tone from the top, routine training, clear policies on using, or serving as part of, so-called “expert networks,” and spot-checks on whether the compliance program is being followed.

6. Be prepared. Develop a plan and provide training on how to react should the Government knock on the door.

How A Hedge Fund Business Should Respond

1. Review your compliance program, particularly your policies and procedures designed to prevent insider trading. Assess whether sufficient resources have been devoted to compliance.

2. Make sure that the use of expert networks or consultants is carefully controlled. Although the use of such resources is not per se illegal, it is a practice that is under scrutiny. A hedge fund should take appropriate steps to ensure that any information it receives is not material nonpublic information, including conducting due diligence on the source of the information.

3. Provide regular training on insider training geared to the investment strategy followed by the fund(s). Make sure that traders understand the risk to the firms reputation and existence were it to be associated with insider trading or any other illegal activity.

4. Prepare for the unexpected. Develop protocols and train employees with respect to: (a) securing information (hard-copy and digital) in the event the fund receives a subpoena; (b) responding to a search warrant; and (c) responding to approaches by law enforcement.

For further input go to the website of the law firm (www.bakermckenzie.com) or contact Marc Litt at +1 212 626 4454 ( or marc.litt@bakermckenzie.com)

A State Pension Plan Hedge Fund Mandate - It Takes a While

2011-05-18T14:25:00.002+01:00

American investing institutions are the dominant source of capital for the hedge fund industry. It is important to understand how and why they act. The Wyoming Retirement System just announced who would be managing its assets for its first hedge fund allocations. The winners of the mandates are not surprising, but here the focus is on the process that resulted in those winners. A search of the internet for references to the Wyoming Retirement System and hedge funds allows you to put together a chronology from the headlines:

June 2001: "Wyoming Studies Alts"

…The Wyoming pension fund is planning to make a decision about whether to push into alternatives investments such as real estate, private equity and hedge funds. ..Plan officials are working with the fund's consultant Buck Consultants.

August 2004: "Wyoming Puts Hedge Funds on the Back Burner"

…Wyoming has been slowly continuing its hedge fund education ... and would likely consider a fund of funds to temper its risk…

November 2004: "Wyoming to Decide on Hedge Funds Next Year"

…The plan has been mulling an allocation to hedge funds for more than a year…Mellon Consultants is advising…

March 2005: "Wyoming Appoints PIMCO for Absolute Return Mandate"

March 2009: "Trent May Joins Wyoming as First CIO"

…Trent May joins from hedge fund Deer Creek Capital Partners…

August 2009: "Wyoming Taps NEPC as General Consultant"

November 2009: "Wyoming Considers Its First Hedge Fund Investment"

… The change of tack has much to do with the retention of New England Pension Consulting as an advisor by the retirement system in September…

April 2010: "Wyoming Board Gives Permission to Invest in Hedge Funds"

August 2010: "Wyoming Puts out Combined Search"

…Wyoming Retirement System, is searching for multiple managers to run up to $560 million combined in a global tactical asset allocation strategy and a global macro hedge fund strategy… The system plans to hire three to six managers for a global macro hedge fund mandate, which will make up 30% of the $560 million. Trent May said the number of managers hired for both investments is dependent on RFP responses. The two investments will make up about 10% of the entire portfolio.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

As a responsible and accountable public body the Wyoming Retirement System has to make available documentation for its processes and meetings. The source document for the combined search is well put together, and can been seen here.

The selection process uses the Due Diligence Questionnaire (DDQ) as the key screening document. The risk/ return data should reduce the list of all applicants down to long list. And the DDQ can be used to get to a short list that can be evaluated for full-blown due diligence. New England Pension Consultants have put together some great questions to ask in addition to those in the standard questionnaire. They are in the full document for which the link has been given. In this case NEPC have used the Greenwich Roundtable Global Macro DDQ as the starting point – and very good that is too, as are all the Roundtable Guides. The following are extracts from the request for proposals for the hedge fund mandate:

Global Macro Hedge Fund Managers

To be considered for appointment as a global macro hedge fund manager pursuant to this proposal, investment management firms shall have not less than:

$250 million of verifiable total firm assets under management
Two (2) years verifiable Global Macro investment experience

List of Requested Documents & Data

DDQ

Pitchbook

Historical Monthly Returns & Monthly AuM in Excel

Organizational Chart

PPM

Biographies of Principles and Investment Professionals

Latest Monthly/Quarterly/Annual Letter & Risk Reports

EVALUATION AND SELECTION

Proposals will be evaluated and subsequent judgments made taking into account the following criteria:

Performance – Return and volatility expectations. While each manager will be evaluated on its relative investment merits the aggregate GTAA allocation will be measured against a 60% MSCI ACWI / 40% Barclays U.S. Aggregate benchmark.

Expertise – (a) Similar work performed for other institutions, with references of such funds to be specified in the proposal; (b) Assets under management; and (c) Investment experience broadly defined and experience in global tactical investments specifically.
Key Personnel – Personnel to be assigned to this account, including key professionals, applicable portfolio managers, back-up and other staff assistance, and education and experience of all such key personnel.
Fees – Reasonableness and competitiveness of fees.

RFP Proposal – Clarity and responsiveness to requirements as requested in the RFP.

Philosophy and Style - the extent to which the proposed philosophy and style best complement existing philosophies and styles and meet the requirements and expectations as presented in this RFP.

Selection Process:
All RFP's will be reviewed with respect to the evaluation of the proposal by the Wyoming Retirement System's staff and the Board's investment consulting firm, New England Pension Consultants (NEPC). WRS' Chief Investment Officer, with the approval of the Executive Director, and in consultation with NEPC will be the sole judge with respect to the final selection of the firm(s) hired.
Finalists will be notified of the results of the RFP selection process as soon as possible following selection; due diligence visits may be arranged with firms who make the finalist list.

The result of the search is that Moore Capital Management, Graham Capital Management, Brevan Howard, Caxton Associates and BlueCrest Capital Management have each been given $30m of capital, and a further global macro manager is expected to be appointed. Although the RFP gives threshold criteria of at least $250m in AUM and a minimum of a 2 year track record, which give scope for dozens of firms to qualify, it is hard to argue against the selections made. Amongst the five named there is a good variety of style, bias by asset class, and differences in pattern of return. It has taken a while in this particular case, but it is easy to see, given the process, why the hedge fund industry continues to get more concentrated as it is driven by American institutional investor flows.

PODCAST FIVE - Sources and Types of Investor Demand As Seen by Third Party Marketers

2011-05-12T15:11:00.000+01:00

Two 3PMs (James Palmer and Jonathan Lee) discuss the state of the industry with Simon Kerr.

Clicking on the link will open a page containing the sound file - download (mp3 format) or play in your browser. The use of a graphic equaliser will probably help the listening experience.

PART ONE (19.25)

Introduction to speakers and firms they represent.

2.38 Offices in different locations

4.26 What does a researcher do at a 3PM?

6.08 Testing a potential manager – chemistry, can they pitch and explain their edge? People, pedigree, performance, protection, process and place

8.34 Environment for capital raising? More competitive than ever. Perception of career risk amongst investors. Getting a "no" is easier.

14.02 US leading the way as investors and as providers of appropriate products.

15.58 Monthly liquidity required in Europe, share classes with better redemption terms

18.35 Demand for reporting status amongst UK investors in hedge funds

PART TWO (14.2)

UCITS - only few American funds going that route

1.22 Funds of funds – Some of big US funds of funds doing very well, smaller ones merging

5.04 Marketing and the increasing prevalence of investment consultants

8.34 How do you approach an investing institution with many layers of decision makers?

12.32 Due diligence changed, sales process changed?

PART THREE (16.0)

Where the demand for hedge fund product is concentrated.

3.20 Bringing American managers to Europe

5.55 Marketability of hedge fund UCITS – new marketing opportunity

8.03 What strategies are in favour? EM managers are still of interest; Increasing interest in market neutral.

12.00 Market environment/cycle good for which strategies? Sector funds have attractions.

PART FOUR (20.43)

Testing prospective managers. The edge, trust, establishing an understanding of outcomes between the external marketer and investment advisor.

3.59 Sourcing managers

6.05 Reporting by managers is response to the greatest current issue of transparency, and helps with capital retention.

10.20 Taking an investor relations role – maintaining dialogue with client

13.22 Dealing with a drawdown – investors buying into a drawdown? Unrealistic expectations from managers. Helping manager manage their time.

16.55 Demand for early stage managers. Critical level of AUM is now $150m. Record in 2008 important.

CONTACT DETAILS

JAMES PALMER
http://redskycapsol.com +44 (0)203 178 2108

JONATHAN LEE
http://www.hydeparkinvestment.com +44 (0) 20 7004 0900

Previous podcasts: ONE, TWO, THREE, FOUR

Mark Anson’s Top Ten Hedge Fund Quotes

2011-05-06T10:27:00.000+01:00

Mark Anson is unusual in having held the top job in a major institutional investor on both sides of the Atlantic. He was Chief Executive Officer of Hermes Pensions Management Ltd., where he was also the Chief Executive Officer of the British Telecom Pension Scheme, the largest pension fund in the United Kingdom. Prior to joining Hermes, He served as the Chief Investment Officer of the California Public Employees' Retirement System, the largest pension fund in the United States. More recently he joined Oak Hill Investment Management, the firm which grew out of Robert Bass's family office, as a Managing Partner and Chair of the Investment Committee.

Over the course of his career he has listened attentively to many pitches by hedge fund managers, and his notes enabled him to compile in 2007 his "Top Ten Quotations from Hedge Fund Managers" which appeared in print this year*. Enjoy.

10. "If we don't charge 2 and 20, no one will take us seriously."

9. "We are 75% cash because we cannot find sufficient investments."

8. "We charge 3 and 30 because that is the only way we can keep our assets under several billion."

7. "We don't invest in crowded shorts."

6. "I haven't shorted before, but I do have my CFA."

5. "Managed Futures are a better investment than Hedge Funds because Hedge Funds are a zero sum game."

4. "What's a Master Trust?"

3. "Your Head of Equity doesn't understand our Hedge Fund strategy."

2. "Basically, I look at the trading screens all day and go with my gut."

1. "He will be with you in a minute sir, he's still meeting with his architect."

*Top Hedge Fund Investors: Stories, Strategies, and Advice (Wiley Finance)

Syz’s Altin Zigs When Others Zag

2011-04-29T10:28:00.002+01:00

ALTIN AG (LSE:AIA) (SWX:ALTN), the Swiss alternative investment company listed on the London and Swiss stock exchanges, discloses quarterly its entire hedge fund portfolio holdings as part of its policy of full transparency to investors initiated in 2009. Looking at the strategy allocation shifts of the fund of funds managed by Banque Syz makes an interesting contrast with the expressed biases of investors in hedge funds given in the Deutsche Bank Alternative Investment Survey.

Graphic 1. Net Allocation Plans by Strategy of Hedge Fund Investors

Source: 2011 Deutsche Bank Alternative Investment Survey

Asked in January this year, the respondents to the survey ranked as the top three strategies for receiving allocations of capital in 2011 as equity long/short, event driven and global macro. So it was striking that the Alternative Asset Advisors SA, the subsidiary of Syz that manages ALTIN AG, had acted in exactly the opposite way over the first three months of the year. As the fourth column in graphic 2 shows the largest reductions in strategy allocations made by 3A were in equity long/short, event driven and global macro.

Sometimes reductions in allocations in portfolios of hedge funds are effected through a passive route. That is as flows come in, net new subscriptions are allocated to preferred strategies, and the strategies or managers with sufficient allocations at that point are diluted. But ALTIN is a closed-ended investment company, so the capital available to invest changes with new capital raisings on the stock exchange and with leverage. There have been no capital raising (in fact shares in ALTIN AG have been bought back), and leverage at the portfolio level is broadly the same over the first three months of the year. So in this case the reductions in allocations to strategy are active decisions based on a number of possible factors. The factors are views on prospective returns at the strategy or individual hedge fund level, and (fund of funds) portfolio composition issues. That is reductions may be driven by bottom-up factors (marginally high allocations to a single fund that needs to be trimmed after very strong performance or changes at the firm), or driven at the highest level of management (portfolio level leverage as a function of hedge fund returns across all strategies), as well as at the intermediate level of strategy allocation. In this case the changes seem to have been made at the intermediate level because two funds have been added that invest using investment strategies that were not represented in the portfolio at year end.

Graphic 2. Breakdown of Capital by Investment Strategy of ALTIN AG

Source: Regulatory News Service of the London Stock Exchange

The two new funds are ZLP Offshore Utility Fund Ltd (an equity market-neutral fund) and Providence MBS Offshore Fund Ltd (a fund investing in mortgage backed securities (MBS), under Fixed Interest Strategy in table above). The first of the new funds is a sector specialist fund that adds value by the application of deep knowledge of one industry. The market-neutral fund, managed by Zimmer Lucas Capital of New York, should produce a return stream with a low correlation with traded markets. The managers of ALTIN know the managers of the fund very well – 3A were early backers of Zimmer Lucas Capital as far back as the year 2000.

The Providence MBS Offshore Fund Ltd is managed by Russell Jeffrey, founder of Providence Investment Management LLC of Providence RI. The $895m fund takes a relative value approach to residential MBS, and capitalizes on price dislocations in the agency MBS and related fixed income markets. The fund has a CAGR of 23.44 % since inception in 2004, and over the last 3 years it is ranked in the top 0.1% of all hedge funds for absolute returns.

The Deutsche Bank survey of investors in hedge funds showed no net interest in investing in either equity market-neutral or dedicated fixed income strategies in 2011. So it is not just in reductions in allocation to strategies that the managers of ALTIN zig when others zag, but also in new subscriptions to hedge fund investment strategies.

Selecting the Best Managers – a natural bias to hedge fund managers?

2011-04-26T16:19:00.000+01:00

I carried out manager research for an American fund of hedge funds for several years early last decade. Manager research and portfolio construction is a team effort so I had to find a way to put across to my colleagues the merits of the managers I followed. We use a lot of inputs to understand how managers manage capital, so in our heads each of us has a multi-faceted view of the portfolio manager and his process, but it is not feasible to put it all across to someone else. So we have to find ways to summarise and capture the essence of our take on the hedge fund manager.

In my case I used a numeric score of what I considered then, and still do now, the key drivers of performance. So I gave each manager a score between 1 and 10 for each of source of alpha and for risk management. Risk management included portfolio construction, position sizing, diversification, risk measurement, downside risk and use of stops. The source of alpha score took into consideration the added value of the specific person/people pulling the trigger, the breadth and depth of research, whether there was a unique or unusual information source being used, the sustainability of the manager's edge, how adaptable the approach was to change, and the richness of the opportunity set being addressed. A mid-ranking manager would score 6 for each, in the way I used the scales, but this was a closed marking system. No manager ever got 10 for either metric. I never gave any manager a score less than 4 for alpha or risk management in the time I carried out manager research. At the bottom end it is easy to understand why: managers setting up a hedge fund have nearly always has significant success previously in trading or investing. They are not neophytes; and though some learn on the job about managing capital in the hedge fund format, they have all managed capital before.

After a while meeting managers, and hearing how they do what they do, I realised that whilst the alpha score was important, risk management was a bigger differentiator. So getting into risk management issues early in the process saved a lot of time and effort: if a manager didn't have discipline and a consistent process in risk management it was time to move on to another hedge fund.

A legacy of this time is that I remain interested in how to assess managers – it is useful in my consultancy work, at the least. In the book I am reading at the moment – "Investing with the Grand Masters" by James Morton – I am engaged to see what criteria the author used for selection of the managers.

So I was interested to read about the Skandia Investment Group's Best Ideas fund range. Skandia has a fund platform and operates multi-manager funds, but the Best Ideas funds are not a standard fund of funds. Neither are they portfolios of pure hedge funds. These are portfolios of funds (mostly long-only funds) run by well-regarded portfolio managers who have been given the freedom to invest in their highest conviction investment ideas on a dedicated basis.

The lead manager on Skandia Investment Group's Best Ideas fund range, Lee Freeman-Shor, applies four key pieces of academic investment research to his selection process. These are:

1. High conviction investing: Research from Randy Cohen of the Harvard Business School, Christopher Polk and Bernhard Silli of the London School of Economics suggests that the bulk of fund manager's returns come from their highest conviction ideas. As a result the Best Ideas managers are limited to holding only ten stocks, their ten highest conviction ideas.

2. Kelly Criterion: a formula first described in 1956 by John Larry Kelly to determine the optimal betting size to maximise wealth. Perhaps the most famous Kelly practitioner is Warren Buffet who once said: 'Why not invest your assets in the companies you really like? In 1972 Buffet had 42% of Berkshires assets in American Express. Freeman-Shor allows the managers to apply Kelly to the extent that they can invest up to 25% in a single stock.

3. High Active Share: this measures the proportion of a fund's assets that differ from the benchmark index. In their 2009 paper 'How Active is your fund manager? A new measure that predicts performance' Martijn Cremers and Anti Petajisto indicated that running a fund with a high 'active share' delivers the highest and most repeatable returns. The European Best Ideas Fund has a high active share, currently 83%.

4. Behavioural science: Research by Andrea Frazzini in 2006 showed that the best performing managers realise the highest proportion of losing trades. Freeman-Shor's job as overall portfolio manager is to be a coach and work with the Best Ideas managers to ensure they do not succumb to, amongst other things, sunken cost bias when they are losing and are thus executing their ideas appropriately.

In a good hedge fund there is a competition for capital between the investment ideas – that is, all full sized positions are conviction ideas. So the concept of high conviction investing is seen in the hedge fund world. The Kelly Criterion applies in several hedge fund strategies – event driven investing, activist investing, and to a lesser extent in global macro investing. The third piece of applied research might just say why hedge funds have inherent qualities relative to long only strategies, as 100% of many hedge fund portfolios are active bets. There are no index constraints in hedge fund portfolios, though the presence of positions held only to hedge impacts the percentage of the portfolio applied to seek alpha.

The fourth piece of academic research applied to the Skandia Best Ideas funds has a very strong resonance for me. The conclusion from Frazzini is that the best performing managers realise the highest proportion of losing trades. From my work with traders I know that this can be applied with minor tweaks in hedge funds: the best traders realise their losses either early, or in line with their stated stop-loss policies. This allows winners to run, and losers to be cut. This characteristic is also often seen in systematic approaches to markets, particularly by CTAs. With good money management it is feasible to run a successful CTA with a hit-rate (percentage of winning trades) of only 35%. The hit-rate in a discretionary money manager has to be a lot higher, and for a fundamentally driven manager with a long holding period the hit-rate can get into the high 80's as a percentage.

The fruit of the application of these concepts has been good – the Skandia European Best Ideas Fund has shown some strong out-perfromance. On the third anniversary since launch the fund was 17% ahead of the MSCI Europe index and 15% ahead of its peer group (Morningstar European Large Cap Blend), putting it in the top 5% of European funds since inception and 1st quartile over all time periods.

There are a number of hedge fund managers and managers of absolute return funds amongst the roster of managers employed by Skandia in the Best Ideas Funds. In fact I would go so far as to say that there is a disproportionate number of such managers amongst the portfolio managers used (see tables below). Would that be because hedge fund managers tend to apply the best portfolio management practices given by Skandia more than long-only managers?

Past the Low Point for Funds of Hedge Funds

2011-04-18T17:32:00.000+01:00

It has been a tough time for funds of hedge funds post the Credit Crunch. At last it looks like the aggregate assets under management are beginning to emerge from the prolonged bottoming phase. Three months ago there was a comment here on the flat-lining in asset flows for North American funds of hedge funds. But the latest survey evidence from Preqin shows a rather more constructive outlook.

Whilst the aggregate is little changed:

Graphic One: Aggregate Fund of Hedge Funds Assets under Management

Source: Preqin

The detail shows that more of the fund of funds sector is experiencing positive changes in AUM:

Graphic Two: Changes in Fund of Hedge Funds' Assets under Management since 2007

Source: Preqin

The proportion of funds of funds experiencing a fall in assets has gone from a substantial minority last year (42%) to only a small minority (17%) this year.
Much more of the industry has experienced stability in AUM this year – 55% of FoFs have seen no change in assets so far this year compared to last year.
The proportion of funds of hedge funds having an increase in assets is up to 28% in the 1Q of 2011.

If these trends continue the total AUM for funds of funds could rise towards $950bn by year end, in Peqin's estimation. This would be a good fit with evidence suggesting that institutional investors will be increasing their allocations to hedge funds. According to the recent Deutsche Bank survey on hedge funds, in aggregate institutional investors do expect to increase their allocations to hedge funds in 2011. The majority of investing institutions (77%) expect to keep their allocations as they were, but more (21%) expect to increase allocations in 2011 than decrease them (2%).

The outlook for funds of hedge funds is the most positive we have seen for at least 3 years. Preqin's version is

"The fund of funds landscape is markedly different to the pre-crisis industry. Assets under management for the industry as a whole are much lower and there is a bimodal distribution of firms emerging, with peaks at the lower end of the scale as the smaller niche boutiques appeal to the maturing hedge fund investors, and at the larger end of the spectrum the "brand name" multi-strategy firms still prove appealing to the newer investor. After a difficult few years for funds of hedge funds, the managers that have appropriately adapted to retain investors from the institutional market have regained some lost confidence and numerous new funds are poised to be launched this year. Growth of industry assets is again in positive territory and if this new era of revived investor interest in funds of funds continues then aggregate AUM will begin to climb towards the $1 trillion mark."

The fund of funds part of the hedge fund industry is not going to return to growth in the way it experienced it before – not all funds of funds will benefit in this more mature phase of the industry. But in aggregate the low point for the sector has been passed.

Consulting Two - No Explicit Cost v Negative Carry Option Strategies

2011-04-07T13:11:00.006+01:00

In my consultancy work I have been surprised by the frequency with which I have come across zero-cost strategies in options. Traders and portfolio managers find them more alluring than they should. It is as if these strategies intrinsically have more merit and deserve more attention. They don't.

To take on an options strategy, in say an equity index, the trader or PM must have a view on the underlying. To have an informed view the trader must follow the instrument closely – this allows them to attach probabilities to the possible broad scenarios behind taking a view via options. So the thinking may be that the index has had a good run and is beginning to act tired; that is there is limited upside from the current level. Or it could be that a particular share has formed a double bottom, there is good value in them and selling might begin to dry up. The first scenario is one that might suit an over-writing of call options. The second might fit an underwriting near current levels by selling put options.

To simplify market activity there are three broad outcomes possible – a trading range, a further significant rise, or a significant fall. Lesser directional movements are captured in the trading range scenario. The money manager or trader will have views on the likelihood of each of these, or to put it another way, if pressed most money managers could attach probabilities to the three broad outcomes. The money manager might have a view that the odds of a significant decline are small, say 10%, but having had a good run the odds of a trading range to consolidate the rise is quite high, say 60%. And the chances of further significant upside are greater than the chances of a significant fall, given the evidence of new buyers – so the odds of a significant rise are 30%. Whatever the exact percentages, the trader will have his own take on what the probabilities are of the three possible outcomes. It is his own probabilities which need to be fed into the construction of an option strategy to make it a fit of his view.

Of course the further significant rise might follow an intermediate pause for refreshment in the price of the shares or index. The extent of time taken to consolidate or pause is a key point. This is the time frame factor, and all managers have a time frame in which they add most value. This is the period over which they generate alpha. If they are a scalper, they shouldn't be taking a view over the next quarter, and a fundamentally-driven stock selector should not be looking to implement a view over the next couple of days. If a manager has a variant perception on earnings, for example, that would normally emerge over several quarters rather than over a week. All option strategies have a time frame, fixed around the months of the option maturities. To be a good fit for the trader the option strategy has to take place over the right forecasting horizon for them.

In a commodity market traders will know the price level at which industrial users will be highly likely to come in to buy. They may know the price zone when commercial hedgers have historically increased their open interest. In the world of equities a manager will have a clear idea of where value is emerging in a particular stock, and where companies buy-in their own stock. In fixed income traders will know at what interest rate funding becomes attractive to a particular category of market participant. So the portfolio manager or trader will have his own mental map of the significant levels of the markets they follow as they see them. In contrast, traded options are bought and sold for strike prices set at intervals by the rules of the exchange on which they trade.

The currency of option trading is volatility. So it might be said that the vol on a class of options is at least a couple of points rich compared to its recent history. Or that the smile of the volatility curve is particularly skewed because of a recent freefall in prices, meaning that out-the-money puts are expensive relative to those with strike prices near-the-money. The 3-D volatility surface is what the options market maker takes his view on.

The users of options may or may not have a view on volatility per se. The users may have opinions on levels and how long it might take for moves to develop and mature, and what probabilities they attach to scenarios for their markets. Professional traders will have a view on vol. Portfolio managers who read a lot of fundamental research and meet company managements are unlikely to have a strong or well-informed view on option volatility by class, never mind by strike. So having done option training, PMs will know what implied and realised volatility are, but it is not the element on which they are typically able to take a well informed view. It is not their currency.

So it is that option strategies are often expressed in the language of levels – strike prices plus or minus net premium. For simplicity pay-off graphs tend to illustrate possible outcomes at maturity. This makes the marketing of strategies more straight forward, and expresses strategies in terms closer to those most readily understood by the widest number of portfolio managers. It does little for suitability or fitting with a manager's market view. And so we come to "zero cost" option strategies.

Zero-Cost Strategies

Zero-cost strategies would not matter much were it not for the frequency with which they are implemented. After all the PMs are all grown-ups and they can always say no to an options strategy proposal. But the allure of the cachet of no explicit cost seems to be very strong with the buy side. So a disproportionate number of strategies are created, sold and implemented based on the appeal of no up-front premium outlay.

The typical circumstances are that, for a give maturity, the premium attached to a near-the-money strike option happens to be twice the premium for an out-the-money strike option. This means that, taking account of one side being on the bid and the other on the offer, an investor can receive as much premium for selling two lots of options O-T-M as they pay for buying one lot of A-T-M options. The payoff profile is rising profit through to the OTM strike, and from that level out a declining profit.

Sometimes the ratio between the strikes dealt in is not 2:1, but say 5:2, but overwhelmingly in reality the zero cost collar or put protection is sold and implemented using a ratio of 2:1. The outcomes are then much more intuitive to comprehend (and pitch).

In the process of putting the strategy together the strike levels and maturity of options are selected to fit the template that the purchased premium outlay should be offset by the premium received from the options sold. Occasionally, when the term sheet is put together by a less experienced sell-sider, the O-T-M option is struck further out in time than the near the money option. This diagonal call spread/put spread is less elegant to sell and understand, and utilises two time horizons.

Now going back to the portfolio manager's use of options, he or she should use traded options when they efficiently implement their views on markets, and within their style of investing/trading. Their views come in several aspects: their own take on what the probabilities are of the (three) possible outcomes in the specific market; their own mental map of the significant levels of the markets; and they should take views via option positions over a time-frame that has a resonance with their own horizon for adding value.

Explicitly stating the elements going into the views on markets makes plain how specific they are to the trader or portfolio manager. It may well be possible to express the market view of a portfolio manager using options – so the time frame, probabilities and significant levels match what can be achieved and structured in the options market. That can be guaranteed to happen using over the counter options; that is, using bespoke instruments. To a degree using pre-existing strikes, dates and a given volatility surface of traded options will always be a compromise versus that ideal fit.

Lay on top of that that zero-cost strategies are put together when there is a conjunction of option maturities, skewness and strikes that just happens to give a ratio of 2:1 in premiums, and the impartial observe can see that zero cost strategies are a very artificial construct. Further it is plain that in order to put them on portfolio managers or traders are quite conceivably having to compromise their own market view in some dimension to accommodate the implied view of the zero-cost option strategy. So the real cost of the zero-cost strategy is not the premium expended, which by definition is nil, but the potential for a significant compromise with the actual market view of the risk taker. This mis-match is too often the cost of the zero-cost option strategy.

Using Negative Carry Strategies

Parenthetically, the inverse of the driver of the zero-cost options strategy, has produced great returns in some hedge funds. Rather than be a net seller of gamma (through being short one unit of O-T-M delta) some of the most successful trades of all time have been long long-dated optionality. Being net long of option premium comes at a cost – there is time-value erosion to cope with. But for some patient investors there is a big attraction in having a negative carry trade which gives well defined upside/downside parameters.

The "greatest trade of all time" is the definitive example of the successful negative carry trade. Mortgage backed securities have embedded optionality in pre-payment risk, but through derivatives on MBS specific tranches and indices it was possible to construct trades that would benefit from no payment risk – when mortgagees hand back the keys on their houses. So it is that the likes of John Paulson and Kyle Bass made billions on the subprime meltdown. There was an explicit cost to the trade, but the downside was known from the outset, and at least in the mind of the originator of the trade the real risks were in rolling over the positions – the collapse was going to happen at some point, though its exact timing was not foreseeable.

A similar set up was seen by Mark Hart of Corriente Capital of Fort Worth Texas. Like Paulson he created a dedicated vehicle to run a long long-dated option strategy to play one specific investment idea for the medium term. In the case of Hart, the fund he created in 2007 with the founders of GavKal, the European Divergence Fund LP, owned credit default swaps on European sovereign risk. Hugh Hendry of Eclectica is hoping for a similar payoff (7:1 and better) from using CDSs for taking negative views on China-related plays.

Another successful manager that uses negative carry options is Jerry Haworth of 36 South Investment Managers of London. 36 South has a diversified fund, the Kohinoor Fund, that only uses long-dated options and which has a 10 year track record. Haworth has also set up funds to benefit from specific tail risk events that use the same approach – for example the Black Sawn Fund that made 234% in 2008.

For each of these managers the use of negative carry option strategies gives a very useful attribute - the left side of the distribution of returns is truncated. That is the range of possible outcomes is limited on one side, which is the classic desirable skewed distribution of hedge funds.

Finally, some successful managers will not engage in negative carry trades with optionality on a structural basis in their fund. Rather for some long established and successful managers they see themselves as earning the right to start to use these strategies once they have passed a return threshold for the year. So once they have earned 8 or 10% (and therefore have every chance of producing a double digit year as a minimum) they will invest some of their profits to give a shot at making a banner year.

When I was Head of Derivatives at Clerical Medical I used to tell the investment professionals there that derivatives should be used to implement their views on markets when the instruments allowed that to be done economically. So in specific circumstances, for a particular money manager, a zero-cost collar may exactly fit their market/stock view. But the investment concept invested in, and the fit of the option tactic with the view is more important than the explicit cost, as the successful examples of the use of negative carry option strategies show.

The first article in this series on consulting in the hedge fund business can be found at Consulting One