Challenges and Innovation in Hedge Fund Management

Overview Rodney N. Sullivan, CFA Vice President of Publications and Editor CFA Institute With roots going back as far as...

Author: Dan Och | Laurence B. Siegel | Gregory J. Nowak | Robert P. Swan III | Clifford S. Asness | Richard D. Marshall | Alain De Coster | S. Donald Sussman | Kevin Kneafsey | S. Luke Ellis

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Overview Rodney N. Sullivan, CFA Vice President of Publications and Editor CFA Institute With roots going back as far as 1949, hedge funds were traditionally the domain of wealthy individuals. But with the volatile investment environment of the past three to five years, institutional investors are increasingly being attracted to hedge funds and their seeming relatively high prospective returns per unit of risk and low correlations with traditional asset classes. In fact, this perceived appeal has ostensibly led investors toward increased allocations to hedge funds. Endowments, for instance, have strongly increased their hedge fund weightings to a level of 6.1 percent in 2003 from 3.1 percent in 1999, according to a 2003 NACUBO (National Association of College and University Business Officers) study.1 Other institutional investors demonstrate a similar trend in investment allocations. This volatile environment coupled with sinking asset values within traditional asset classes has demonstrated the need for investment managers to consider new approaches. In large part, this need also relates to investors’ long-term return assumptions. For pension plans, the average long-term rate of return assumption was a lofty 8.6 percent in 2003.2 Whether this observed “need” is reasonable and can thus be translated into realized future returns remains to be seen. As others have said before, “Hope is not a strategy!”

Sources of Change The increasing institutionalization of hedge funds brings with it many challenges. These challenges are fostering change and innovation regarding hedge fund management. Clifford Asness faces these challenges head on and provides an assessment of key issues that will arise as a consequence of institutionalization. He finds several notable changes that are under way in the areas of benchmarking, transparency, fees, and risk management. It is well known that institutional investors require performance benchmarking for managers. Asness covers several ways to accomplish this task, and in the end, he suggests using a series of multiple benchmarks to better match 1

See Jay A. Yoder, Endowment Management: A Practical Guide (Washington, DC: Association of Governing Boards of Universities and Colleges, 2004):60. 2 Rob Kozlowski, “Big Contributions, Returns Cut Pension Liabilities 41%,” Pensions & Investments (12 July 2004):1.

©2004, CFA Institute • cfa pubs.org

differing portfolio objectives. A hotly debated issue that has been an ongoing source of concern relates to the degree of manager transparency. To alleviate concerns, he advocates a form of transparency that has great potential for meeting varied (and often competing) investor and manager needs. His approach involves creating a detailed description of the investment process and strategies in an open and transparent way. Another contentious issue is that of hedge fund fees. In discussing this issue, Asness emphasizes the importance of separating fees by distinguishing between returns from the more valuable unsystematic alpha relative to the less valuable systematic beta. Methods for risk control are a final source of change. The establishment of an ongoing risk control system to identify and understand sources of risk is quite simply essential to a successful hedge fund operation. Dovetailing into the discussion on changes in the hedge fund industry, Dan Och suggests that successful hedge fund firms will be innovators in a continuous effort to keep pace with the dynamic and evolving investment environment. He emphasizes that this environment will undoubtedly be more competitive, so innovation will be a necessary ingredient for successfully adding value. One such innovative, value-added approach is to seek new areas for investment opportunities. A prime example of this strategy is to find and exploit solutions to the market’s increasingly complex financial problems.

Risk and Return As Asness mentions, investors must be able to understand and separate sources of risk and return. In 1964, Bill Sharpe devised a ground-breaking method for separating policy risk (beta) from active risk (alpha). Laurence Siegel offers an enlightening discussion by delving further and helping to make sense of the policy and active-risk components that comprise a portfolio. He further relates that applying these concepts to alternative investment strategies is rather straightforward. In separating alpha from beta in hedge funds, he offers his own insights as well as insights by other key industry thinkers. He identifies and differentiates the alpha and beta portfolio components and offers constructive models for assisting in this task that have proven quite useful historically CFA Institute Conference Proceedings • 1

Challenges and Innovation in Hedge Fund Management

when applied to hedge fund strategies. For instance, he points to a Bridgewater study that successfully relates the return performance of the popular managed futures strategy to a series of straightforward momentum strategy trades. He concludes by advocating policy implications for investors. A primary focus of asset management involves developing portfolio policy. This task is accomplished, in large part, by assessing prospective returns and corresponding risks across various asset classes and hedge fund strategies. As mentioned earlier, risk controls are indeed an important aspect for those using hedge funds. Kevin Kneafsey puts forth the notion that investors can improve on policy portfolio formulation and recommends a superior approach for wrestling with the policy portfolio challenge. In part, he stresses, as does Siegel, the importance of separating alpha and beta exposures. He extends the discussion by offering the important insight that the portfolio should be optimized on an overall basis to provide the most consistency at the plan level; optimizing alpha and beta sources separately is suboptimal. So, why separate alpha and beta exposures at all? The answer is that beta risk is relatively easy to find and can be hedged away, thereby allowing alpha risk to be ported. The hard part is finding the alpha sources, in his view.

Funds of Funds The growth and inherent complexities of hedge fund investment strategies has led to the introduction of firms that specialize in analyzing and recommending hedge fund managers and strategies to investors. Funds of funds provide an important resource for ongoing monitoring and assessment of alternative strategies and corresponding risks. Once again, as Asness and others have mentioned, it is vital for an individual hedge fund manager to implement an internal, robust, risk control system. It is equally important for a manager using a pool of hedge funds to assess and monitor the risk of both the individual managers and the portfolio of managers as a whole. Funds of funds support this need by providing proactive tools for analyzing the many risks and how these risks might affect the risk–return profile of the overall plan. The investigation of the usefulness of funds of funds begins with a discussion by Luke Ellis on how best to identify and manage the risks in a portfolio of hedge funds. He advocates a modified value-at-risk method by which to understand and model the wellknown “fat tails” problems associated with nonnormal return distributions. He advocates separating the fat tail problem into two parts. The first compo2 • CFA Institute Conference Proceedings

nent is the fat tail events that are prominently exposed in market crisis periods. The second is the fat tail risk associated with risk levels present in “normal” or noncrisis periods. Alain De Coster makes the valid point that many elements of risk are inherent in hedge funds and that hedge fund strategies thus do not necessarily lend themselves to traditional risk measurement and management approaches. Several often overlooked elements are of equal importance to strategy and implementation risk. These often overlooked risk factors include redemption characteristics, investor profiles, equity ownership, and motivation policies. Donald Sussman agrees with his peers that the rapid growth of hedge funds will ultimately lead to diminished alpha opportunities. He notes that this quest for alpha is most often found among hedge fund firms in the early parts of their hedge fund life cycle. He supports his claim with simple yet compelling statistics while illustrating its intuitive appeal. Not forgotten are the operational risks in which the challenge is to locate managers early in their life cycle—managers that also have robust operational controls and infrastructure. He cites a study finding that 50 percent of all hedge fund failures are caused by operational risk alone, rather than bad investment decisions. Such operational failures as fraud, misappropriation of funds, and the mispricing of positions are the leading culprits. The focus on funds of funds is concluded, appropriately, with a discussion on due diligence by Robert Swan. Swan gives 10 commandments of an effective due diligence process. By following his commandments, investors will be equipped to ferret out managers’ operational weaknesses and risks and thus avoid the many operational problems that often lead to hedge fund blowups.

Regulation A historical perspective is useful in gaining an understanding of the unique and seemingly opaque world of hedge fund investing regulation. As a former regulator with the U.S. SEC, Richard Marshall is well equipped to give just such a perspective. Marshall walks us from the early days of the hedge fund regulatory climate of seeming indifference to the heightened concerns of the scandalous period currently surrounding the industry. He concludes that a variety of hedge fund legislative proposals and potential changes are gaining momentum, which will undoubtedly lead to greater oversight of the hedge fund industry. Finally, Gregory Nowak emphasizes the importance of fully understanding regulations that are new and upcoming as well as rules likely to be adopted. He stresses that many issues and rules ©2004, CFA Institute • cfa pubs.org

Overview

are being developed. He offers a highly useful overview of the hottest topics, including the September 2003 hedge fund report and the compliance programs that the SEC mandated in its December 2003 release.

Conclusion These tremendous insights from industry practitioners and experts fortunately come at a time when hedge funds are quickly moving from being rela-


tively obscure and arcane to being accepted and embraced by a wide variety of investors. Concurrently, the industry is facing many hurdles as it evolves from a cottage industry to a true market force. As with any period of transformation and its accompanying turbulence, those who can keep pace with changes and information are in the best position to reap the benefits. In that regard, we hope this proceedings contributes to your success.

CFA Institute Conference Proceedings • 3

Sources of Change and Risk for Hedge Funds Clifford S. Asness Managing and Founding Principal AQR Capital Management, LLC New York City

A lot of change is on the horizon for hedge funds, particularly given institutional investors’ growing use of alternative investments. The changes will likely bring a greater focus on benchmarking, calls for increased transparency, a need for better articulation of investment strategies, rationalization of hedge fund fees, and the need for solid risk control mechanisms. The future also brings subtle shifts in hedge fund risk. And although the risk of blowups still exists, perhaps the larger future risk will relate to diminished returns.

n this presentation, I will take a big picture view of the hedge fund world, but the core of the presentation will relate to an idea that is coming up ever more frequently—hedge funds are becoming much more institutionalized. Although institutionalization can mean many different things, I will jump right in and describe it through a focus on five key issues that come up as a consequence of institutionalization: benchmarking, transparency, articulation of the investment strategy, fee rationalization, and risk control.

I

Benchmarking For better or worse, institutionalization brings about a greater focus on benchmarking. And a myriad of ways exist to set up a benchmark depending on whether the investor wants to analyze an individual hedge fund manager or a hedge fund program. Probably one of the most basic benchmarks is a simple absolute number, which could be any number that the manager and client agree on. Of course, an absolute number makes little sense in a world where inflation and interest rates move around. Because getting around that problem is difficult, another level of benchmarking adjusts for changes in inflation and interest rates. At this level, investors will typically see an absolute number that is some proxy for a risk premium plus a measure for rates, such as 6 percent plus T-bills or the U.S. Consumer Price Index (CPI). But if investors are going to Editor’s Note: The joint Question and Answer Session of Clifford Asness and Dan Och follows Dan Och’s presentation.

4 • CFA Institute Conference Proceedings

recognize an external influence, such as rates, why not go a step further and recognize that many hedge fund strategies have at least some exposure to market performance? Even if the correlation of hedge funds with the market is supposed to be low, bad years for the market are tougher-than-normal years for hedge funds. Moreover, some explicit market beta is built into certain strategies, such as long–short equity. In recognition of that exposure, the third level of benchmarking includes adding an element of market performance to the equation (e.g., ½CPI + 3 percent + ½S&P 500 Index). The final approach simply involves peer group or index comparisons. This approach, versus the others I have discussed, is helpful in discovering consistent under- or overperformance relative to other hedge fund managers. Granted, investors certainly want to know how their manager is performing relative to the other managers they could have selected, but a weakness of this approach is that it says nothing about whether the investor made a good choice to be in hedge funds to begin with. So, what is the solution to the benchmarking problem? My recommendation is to use multiple benchmarks because the major issue to recognize is the impact of the time horizon. Of the different methods I have pointed out, the one closest to being demonstrably silly is the single, absolute number that moves with nothing. But even that benchmark might be relatively fair if the investor is applying it over a 20-year horizon, during which time one can assume that inflation and interest rates mean revert.


Sources of Change and Risk for Hedge Funds

Going a step further and adding an inflation or interest rate component makes the benchmark more useful over a shorter period because what all managers earn is T-bills plus or minus something. By that reasoning, adding a stock market exposure helps match the shorter term even better. And using a peer benchmark matches the short term the best. Unfortunately, the trade-off an investor makes when using a benchmark with a shorter-term orientation is that the benchmark tends to be much less useful for comparing the investment program with the investor’s long-term goals, which is why I advocate using multiple benchmark types that are useful at different time horizons.

Transparency Transparency is certainly a major institutional concern. As hedge funds have become more institutionalized, the issue has only become more significant because of the wide variety of reasons why hedge fund managers shun full transparency: • Revealing proprietary strategies. Primary among hedge fund managers’ concerns about transparency is that revealing positions on a timely basis may help competitors determine the investment strategy. • Vulnerability. At certain times, sharing information about open positions could potentially be harmful to the portfolio. For example, if a manager is short something and vulnerable to a squeeze, it is in his or her best interest not to let the world see this open position. • Logistics. One of the biggest, unheralded concerns about transparency is that offering full transparency takes a lot of time and resources. I will give an example. When I was with Goldman Sachs & Company, we tried an experiment that involved providing full daily transparency to the risk management arm of the firm. We found that simply getting our positions to the risk management group on a daily basis and having everyone agree on how to value many of the exotic positions ended up consuming a lot of time for our back office and a fair amount of time for our portfolio managers. And it was our own firm, albeit a different division. • Black hole. Many hedge fund managers believe that a lot of the time and resources devoted to transparency are wasted because the information is ultimately not used (i.e., it appears to go into a black hole). Providing transparency seems to bother managers less when the information goes to the client so that the client can get a better feel for the strategy. Unfortunately, that information often seems to be provided simply for the sake of the client’s marketing, and the data are never used in the decision-making process. ©2004, CFA Institute • cfa pubs.org

Having actually tried various forms of transparency, what I have found to work best are a mutually agreed upon summary risk report and what we call “process transparency.” By process transparency, what I mean is that we are willing to show clients what we actually do at AQR Capital Management in a generic, but fairly open, sense. Many clients are comfortable with this approach. But in the end, the exact solution varies among clients.

Articulation of Investment Strategy Describing and explaining the investment strategy are critical issues for institutional investors. That is, they want to go beyond the results and understand why the process should work going forward. So, how do managers describe and explain hedge fund returns? Like almost every other part of finance, one can think of returns as coming from three sources: Return = Alpha + Beta(s) + Noise.

I will start with the middle term, beta. In this instance, I am not necessarily talking about market beta. Rather, beta can be thought of as a simple dynamic hedge fund strategy. Just as an example, consider a merger arbitrage strategy. A hedge fund merger arbitrage manager is unlikely to participate in every deal. But one can think of that universe of all deals as a benchmark because the hedge fund strategy is drawing from that pool of deals as a systematic source of return. So, in this case, one might think of beta as “what if the manager had done all the deals?” From that point, the alpha relates to the manager’s skill, or lack of skill, in selecting from the pool of available opportunities. What is left is noise, which I believe shows up in any honest expression of return. The noise term thus captures the random things that affected performance but that were not the result of beta or manager skill. That is, noise is simply the fact that “alpha” is not something managers always get, which means if a manager’s average alpha is 2 percent, some quarters or years the manager will get it wrong and lose. That “loss” does not mean the manager’s alpha or skill is lower than before, just that the manager got that one wrong. To further clarify sources of return, examples are shown in Exhibit 1. For instance, I have already described in general what these managers do for merger arbitrage. Their beta is derived from the average spread. That is, the market is scared, and the returns are skewed to deals once they have been announced. The average spread thus overcomes the occasional failed deal and provides a small amount of average return for taking risk. One potential source of alpha within this framework amounts to better underwriting, which means using skill to predict CFA Institute Conference Proceedings • 5


Exhibit 1. Fund Strategy

Example Return Sources for Several Hedge Fund Strategies What the Manager Does

Potential Systematic Profit Source (beta)

Potential Manager Skill (alpha)

Convertible arbitrage

Long embedded option from The market systematically pays the convertibles hedged with stock. manager for taking on the unfamiliar/ uncomfortable/illiquid convertible.

Better bond selection, dynamic leverage, more accurate hedge ratios.

Equity market neutral

Long–short under-/overpriced Expected returns on cheap stocks exceed stocks over intermediate term. those on expensive stocks.

Other factors (e.g., momentum) to attempt to improve timing aspect of value strategy, specific security-selection skill.

Merger arbitrage

Long a target and short an acquirer where spread is not fully closed.

More accurate underwriting by better deal selection, better risk management, dynamic leverage.

Statistical arbitrage

Long and short a hedged stock The market systematically pays the manportfolio based on short-term ager for providing short-term insurance supply and demand anomalies. and liquidity, perhaps against large information trades.

The market systematically pays the manager to provide insurance that deals close (i.e., the average spread overcomes the failures).

which deals will close and which deals will not. Another source of alpha relates to risk management. For example, increasing the number of deals in a portfolio just because spreads are tighter is not necessarily wise. Being smart about how much risk is taken and dynamically varying how many deals are in the portfolio are clearly potential sources of alpha. Now, consider convertible arbitrage, which is another traditional hedge fund strategy. In this case, the strategy is to go long on a convertible security and dynamically hedge the equity exposure. If the manager takes every opportunity the market puts forth, then the manager gets paid some amount for providing liquidity to a market that needs it (this is beta). Obviously, managing volatility exposure, managing credit exposure, and deciding which converts are worth buying can all be potential sources of alpha. Therefore, as in other parts of the market, dividing up how one thinks of hedge fund returns can be useful in explaining performance in an institutional framework. Beta is the portion of return that comes from systematically taking risks. Alpha relates to the manager’s ability to add additional value through the exercise of skill.

Fee Rationalization In contrast to individual investors, institutions tend to focus more on expenses. One of the strangest things I have heard in the hedge fund world is that fees must fall because institutions are coming and institutions like lower fees. If that scenario were true, it would make for the world’s only case where the price must fall because demand for the good is skyrocketing. That notion is a strange leap of logic. Nonetheless, I think institutions will apply a greater discipline to hedge fund pricing. Additionally, they 6 • CFA Institute Conference Proceedings

Lower cost trading, better systems for removing unintended bets, other shortterm factors.

will certainly apply better performance attribution to the process. Over the long haul, supply and demand will reach equilibrium and managers will be paid what they are truly worth. But that process will take quite a while. In the short term, hedge fund fees will rise or at least stay stable as demand increases. So, the problem for the longer term is to determine what managers are really worth. Alpha is true skill, which can only be found in a handful of places. Alpha is, of course, always in high demand. So, the price of alpha will likely remain high. The price for beta—for just executing one of these hedge fund strategies—should be lower than the price for alpha, although I would argue that the price for hedge fund beta should remain higher than that of beta in the stock market; the skill and market knowledge necessary to implement many hedge funds strategies are considerably greater than the skill and market knowledge needed to replicate a stock index.

Risk Control Having a concern about risk control is certainly not unique to institutions. But it is an area where institutions are more apt to focus. Generally, I believe that the second worst thing a hedge fund manager can do is to operate without a solid system for risk control. The worst thing a manager can do is to lose his or her cynicism about the risk management system that is in place. Building a good risk system is probably one of the areas where I have spent the most time in my professional life. As one can image, trying to measure risk within a hedge fund can become quite complicated considering all the different variances, covariances, frequencies, and weights within a portfolio. On top of all that work, we at AQR believe strongly ©2004, CFA Institute • cfa pubs.org


in a human element. We give ourselves one-way authority to take less risk than what our models are calling for. We do not, however, give ourselves twoway authority, which would allow us to increase risk, for instance, if we were in a good mood that morning. Three specific sources of risk—beta, leverage, and headline risk—are important to institutions, so I will cover these three in more detail in the following sections and then discuss current hedge fund risks. Beta. A few years ago, I co-wrote a paper that, at the time, was fairly controversial.1 Our thesis was that hedge funds not only have beta; they have more beta than people tend to predict. Our experience since the paper was published has continued to support that conclusion. Figure 1 illustrates my point. The gray line represents the rolling 12-month return of long–short equity strategies as measured by the CSFB/Tremont Equity Long–Short Index. The dark line represents the rolling 12-month return of the S&P 500. The good news is that the hedge funds tended to hold up relatively well in the bear market. They lost some money, but they certainly held up better than the stock market. The bad news is that investors cannot look at these lines without spotting the correlation between hedge fund and stock fund performance, which is an important note to keep in mind while allocating a portfolio. The moral of the story is that many investors tend to underestimate beta for hedge fund strategies. 1

Clifford S. Asness, Robert J. Krail, and John M. Liew, “Do Hedge Funds Hedge?” Journal of Portfolio Management (Fall 2001):6–19.

Figure 1.

Leverage. Another aspect of risk control is leverage, the “L word.” Leverage strategies have been called the financial equivalent of picking up pennies in front of a steamroller. Why do people do it? Because that is where the pennies are, to paraphrase the infamous 1930s bank robber Willy Sutton. That is, pennies get readily picked up by others when they are not in front of a steamroller. What are the pros and cons of leverage? The first question I always think about with leverage is: Am I indifferent to leverage even if the volatilities come out the same? My answer is no. All else being equal, I would prefer an unlevered trade to a levered trade. Leveraged trades push a manager’s assumptions further if he or she gets something wrong, which is especially true if the manager is operating in a relatively illiquid market. Of course, using leverage does have some pros. It allows the manager to take advantage of smaller mispricings that certainly exist. And if leverage did not scare people, a lot of these trades would go away much more quickly. In the end, managers must ask themselves why they get paid in the form of uncorrelated positive alpha for something that is exceptionally comfortable and easy to stomach (i.e., no leverage). They generally do not. They get paid for accepting risk, and leverage is one of the risks. Headline Risk. Institutions often have a tremendous concern with headline risk. They certainly do not want to go before their board and discuss owning the hedge fund that “blew up” last month and that is in all the papers.

Rolling One-Year Returns vs. T-Bills, January 1994–January 2004

Return (%) 70 60 CSFB/Tremont Equity Long−Short

50 40

S&P 500

30 20 10 0 −10 −20 −30 −40 1/94

1/95

1/96

1/97

1/98

1/99

1/00

1/01

1/02

1/03

1/04

Source: Based on data from CSFB/Tremont.




A blowup is often a manager’s fault, and is something for which a manager should be held accountable. Obviously, everyone wants to avoid being involved with a blowup. But there is one thing investors should at least keep in mind about blowups: If investors pursue hedge funds, then it is their job to minimize the chances of holding a fund that will blow up. A hedge fund manager’s job, of course, is to avoid letting a blowup happen. But blowups are going to happen from time to time because the purpose of hedge fund investing versus traditional investing is to loosen the strings, to relax the constraints, and to let managers use some more esoteric tools. One must thus focus on how the total hedge fund portfolio is doing, not the worst (or best) part. Just as a year in which the S&P 500 goes up 30 percent still has many disastrous companies, a pool of excellent hedge fund performers can still have disastrous hedge funds. Current Hedge Fund Risks. So, what are the current risks of hedge funds? I like to use the “Fire and Ice” analogy, borrowed from Robert Frost: Some say the earth will end in fire, Some say in ice. From what I’ve tasted of desire I hold with those who favor fire. But if it had to perish twice, I think I know enough of hate To know that for destruction ice

Figure 2.

Is also great And would suffice. — Robert Frost, Harper’s Magazine, December 1920

I think of risk in terms of fire and ice. Fire is the risk of destruction, a big short-term blowup. Ice is the risk of boring people to death for 10 years with poorerthan-expected medium- to long-term returns. Figure 2 shows the rolling two-year volatility of the CSFB/Tremont Hedge Fund Index, which is an aggregate hedge fund index. As illustrated by the recent significant drop in volatility, hedge funds are tending toward a lot less risk than they had in the 1990s. Part of the reason for the decline in volatility is related to a market timing call, in that they got the bubble more right than wrong, although there are other reasons that I will discuss soon. ■ Fire. So, what is the risk of fire today? I believe hedge funds have at least three fire risks. The first relates to momentum strategies. Many hedge fund managers, especially long–short equity managers, follow a trend momentum strategy in setting their beta. That approach worked well over the past 10 years when the market trended fairly consistently. The only time this strategy does not work well is during periods with a lot of whipsaw activity in prices, especially if the market makes sharp changes in direction. A second fire risk relates to out-of-the-money option writing. Estimating how much of this type of option writing is going on is difficult, but it seems to

Rolling Two-Year Volatility of CSFB/Tremont Hedge Fund Index, December 1995–January 2004

Two-Year Volatility (%) 14 12 10 8 6 4 2 0 12/95

12/96

12/97

12/98

12/99

12/00

12/01

12/02

12/03

Source: Based on data from CSFB/Tremont.




be fairly common. The cause for concern about this strategy is that it can lead to trouble very quickly if market volatility suddenly increases. The third wild card is guaranteed products. I call it “October 1987 meets August 1998” in reference to a portfolio insurance–type structure meeting a hedge fund–style blowup. That scenario is obviously a potential fear. ■ Ice. Of fire and ice, I think that ice is actually the bigger risk. One of the easier risks to identify is that of low cash rates. If cash stays historically low for a considerable period, investors will likely see lower returns and for some reason be surprised that these lower returns show up in hedge funds. Perhaps a more subtle danger is that of risk and leverage reduction, as I pointed out in Figure 2. Investors should ask


themselves why risk and leverage have been reduced so dramatically. Some of the reduction stems from a benign shift to lower volatility strategies, such as absolute return—but not all of it. Another cause for the reduction is that some hedge fund returns have come historically from beta, but faith in this source of return has been shaken for many. A third cause for reduced volatility and risk is that spreads on many strategies are tight and managers are rationally taking less risk. In other words, hedge funds have taken in a lot of dollars and have taken lower risk by not investing a lot of those dollars. They are not necessarily selling what they have, but they are not investing it as aggressively either. By and large, I will not rule out fire, but I think the bigger risk facing the industry is ice.


Q&A: Asness and Och

Question and Answer Session Clifford S. Asness Dan Och Question: Is there a way for hedge funds to convince their investors that the performance part of fees is more important than the fixed fees? Asness: An extreme view might be that the fixed fee should be just enough to pay for the hedge fund’s expenses. In that instance, the manager would only make money when the hedge fund produces a return. If you view the world as all alpha, a pure performance fee on alpha might make sense. But to the extent you view the hedge fund world as also providing some beta exposure, it makes almost no sense. So, the fixed fee aspect comes from simply executing the strategy as agreed upon. The performance fee comes into play to the extent that a manager believes that he or she can deliver superior returns versus other managers. I cannot say exactly what the right split should be, but I think that the performance fee/fixed fee framework is the best starting point. The fixed fee comes in to the extent that a manager is providing exposure to a strategy. The performance fee is added in proportion to the extra value that the manager can deliver. So, I like the split into both fees, but I think performance fees should start to move to being net of hedge fund “beta.” Och: I would answer that question slightly differently. How do you make sure that the interests of the manager, the other hedge fund partners, and the hedge fund employees are all aligned with the investors’ interests? I don’t think there is a magic formula or mix for fees. I think any formula is fine as long as it addresses that question satisfactorily. ©2004, CFA Institute • cfa pubs.org

Question: Could you give some examples of the worst types of style drift? Och: First, something that should clearly bother the investor regardless of whether it works is a change that the investor was not told about. I think that situation is unacceptable, period. End of discussion. Second, if the manager or the risk control system and process that you assume were in place were not actually monitoring what was being done and what was going on, that is absolutely unacceptable from a business point of view. Third, and I think this is the most important, if the amount of risk and types of risk are substantially different from the investor’s expectations, that is totally unacceptable. Let me differentiate between evolution and style drift with an example. If a manager puts 2 percent of the portfolio in statistical arbitrage as part of what the manager calls an evolution, I think the manager can fairly argue that he or she is planting a seed in hopes of growing something in the future. In other words, the time and resources spent in exploring the alternative are a fair balance with the potential future benefit. Compare that situation with what was probably the most egregious example of style drift ever—Russian bonds. A large number of firms were holding Russian bonds when they collapsed. Those firms had no business owning Russian bonds. In many cases, they held the bonds as a result of increased risk tolerance in search of higher returns.

Asness: A similar thing happened in 1994 when a lot of managers who had established themselves as stock pickers were suddenly doing the European bond conversion trade. Just because a lot of other smart people seem to be doing it, it doesn’t mean it is a great reason to give it a shot. That is style drift, not evolution. Question: Can you comment on what seems to be a small trend of charging reduced performance fees below high watermarks? Och: I think what these firms are doing is being done with the right intent. It remains to be seen if investors will like it or not. I don’t know the exact terms, but I believe these firms have proposed a system in which they are paid a reduced incentive if they lose money and will stay with the reduced compensation level until they achieve a certain premium. Ultimately, I would worry about the firm losing some of its best people if it loses too much in a tough year and the watermark is too high. My firm is not considering making any changes at this point. We’re going to wait. If our investors come to us seeking a change like this, then we might be amenable, but at this point, we are not planning to make such a change. Asness: I assume you mean the structure where a smaller performance fee is imposed under the high watermark but it is made back after you reach the high watermark and go up more, right? We have also not made this change at my firm, and we are not planning to. But it is interesting.



I would even go a step further and say that you do not want people to fear losses so much. A hedge fund manager is being paid to take calculated, planned risks. You don’t want to create a situation where the manager may have difficulty properly executing the investment strategy because of risks. Finally, if the investor has a long-term perspective and if the investor thinks the manager is a good manager who will eventually come back, then it really doesn’t matter much. And if you think returns are never coming back, you probably shouldn’t be staying! Question: If you were to manage half the assets you have today, what do you believe the impact would be on your performance? Asness: Positive. You are not being honest if you don’t admit that there is a curve. On the x-axis is assets under management, and on the y-axis is the achievable Sharpe ratio. There are arguments that adding assets helps build the resources to where a manager can buy the right teams and abilities. But that becomes a weak argument after a certain point. In other words, once you get past a certain point, additional assets begin reducing achievable performance. I think it is just dishonest to say that the difference between $2 billion, $5 billion, and $10 billion is not a drop in the Sharpe ratio. Ultimately, we have tried very hard to be on a gradual part of that slope. Being a multistrategy fund, our strategies have different capacities. We have been fairly aggressive at limiting the growth. In fact, in some cases, we have closed a fund that does all the strategies and have sometimes closed subfunds that do some of the lower-capacity strategies. When we start other

funds, we are honest with our clients. Although we think they can still do well, the Sharpe ratio cannot be the same. Question: Given the trend toward specialized areas of expertise, how do you train people who can evolve in a multistrategy firm? Och: During the 1980s and early 1990s, I spent 11 years at Goldman Sachs & Company where I learned how important it is to hire and train the smartest people you can find and then retain them. There is something else, which is subtle, but important and rare. You have to make sure everyone in your firm knows that if he or she is supervising three junior people and two years later the three junior people are all contributing more, then that supervisor will be rewarded for creating these winners, not told “thanks very much but we don’t need you anymore.” You must train people in your framework and methodology. If you took 15 of our investment professionals aside and asked each one “what kind of questions would Dan Och ask for each of these scenarios, what would he think the risks would be, and what would his approach be like?” I think they would all give the same answer. If you then said, “What would your approach be, and what do you think we should do?” you would get some different answers. Finally, and most important, if they were asked what would happen if they disagreed with me, the answer would be, “If I disagree with him, then I have to get right in front of him. If I agree with him, he doesn’t need to hear it from me right away.” That is essential. In addition, you have to recognize that your goal has to be to hire people who are smarter than you


are and better than you are at a lot of different things. We have a lot of people at our firm who I know are better than me at what they do. They might be better than me at it because it is all they do, and they might be better than me because they were just born better at it than I am. I don’t really care. The goal is to encourage that rather than to fight that. Last, you have to create an environment of flexibility and opportunity. People are smart. If they see that when there is opportunity within the firm it is given to someone within the firm, they will decide to make a career in your firm and they will work to keep getting better because they never know when their opportunity will arise. Question: Where will the next 10 hires you make at AQR come from? Asness: This is an interesting question. I’m going to answer from the portfolio management and research side. If you looked at the operations on the other side, those have been almost exclusively lateral hires for us. The research and trading hires we’ve made have almost exclusively been undergraduates. We look for geeks who are at least interested in finance, or even better have at least studied finance a bit. The perfect candidate is an MIT computer science graduate who is auditing classes in the business school. We continually debate, and I’ll say we have not done this yet, making a more senior lateral hire. We’ve vetted a lot of different people, and we’ve debated the pros and cons. But to date, hiring the smartest undergraduates we can find has been the best strategy for us.


Opportunities and Challenges in Absolute-Return Hedge Funds Dan Och Founder and Senior Managing Member Och-Ziff Capital Management Group New York City

The traditional model followed by absolute-return hedge funds is unlikely to remain as successful as it has been. As competition among hedge fund firms continues to increase, successful firms will stay within their core businesses and stick with their investment mandates while still finding ways to embark on continuous, well-planned evolution of their businesses to keep pace with changes in the environment.

n this presentation on absolute-return (or nondirectional) hedge fund strategies, I will first talk about absolute-return strategy expectations from both investors’ and managers’ points of view. Then, I will delve into a discussion of absolute-return strategy models—the traditional model, our model at Och-Ziff Capital Management Group, and the evolution of models. Finally, I will point out some of the difficulties and opportunities that are likely to surface in the near future.

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Strategy Expectations Investors’ expectations from an absolute-return fund are generally expressed in quantitative terms, such as low volatility, high Sharpe ratio, and low correlation coefficient. My view is that statistical analysis is an excellent ex post measurement of whether a manager achieved his or her goals. It is also a simplistic way to screen managers. If a manager did not historically achieve low volatility, a high Sharpe ratio, and low correlation with equities, then that manager is probably not worth the time it takes to conduct proper due diligence. This poor past performance does not mean that the manager will continue to perform poorly. But the investor is not responsible for determining how every single hedge fund will perform. Rather, the investor’s role is to simply select the hedge fund in which he or she wants to invest. As a manager, I approach my role in qualitative terms. I think of absolute returns as generating relatively consistent, positive returns (i.e., not losing


money). Of course, every manager will lose money occasionally, but the manager’s role is to make sure that loss is small and not correlated with the rest of the portfolio. Most important, the loss should come as a result of doing exactly what the manager told investors he or she was going to do rather than from straying from the stated strategy, which brings me to an extremely important point. This point will sound incredibly simple, but people tend to miss it a lot: When risk increases and reward or opportunity decreases, managers should reduce exposure. Now, does that not sound obvious? Let me give a great example of where that point is being missed. Someone recently asked me if I am leveraging merger arbitrage now that spreads are tighter. In essence, what that question really is asking is, because nothing has changed, except that returns have been reduced to an unsatisfactory level, am I using leverage, and obviously taking substantially more risk, to generate the same return? Leveraging merger arbitrage because the spreads have gotten too tight is a bad strategy. Many managers find that notion of reducing exposure when risk increases and return decreases to be easier said than done. It essentially means that when managers find themselves with less investment opportunities in their area of particular expertise, they have to either build alternative strategies in advance or build a cash position. Both alternatives can be difficult. Although the quantitative analysis behind a strategy may be complex, the ultimate strategy should be relatively simplistic with low leverage,


Opportunities and Challenges in Absolute-Return Hedge Funds

minimal concentration, and adequate diversification. Moreover, the weaknesses of statistical analysis must be kept in mind. Speaking to that point, Andre Perold, a professor at Harvard University, shows a chart in one of his seminars. The chart contains a host of statistics on a hedge fund. Based on those statistics, just about every seminar participant agrees that the fund looks like a great investment. Professor Perold then reveals that the hedge fund shown in the chart is Long-Term Capital Management prior to July 1998. That example clearly shows how statistics describe only part of the story; they do not necessarily describe underlying risks or underlying capabilities.

Absolute-Return Models The traditional model for an absolute-return hedge fund is quite narrow; our model at Och-Ziff is, by contrast, broad and relies on making sure our strategy evolves appropriately with the environment. Traditional. The traditional model of a nondirectional, absolute-return firm is generally to have two strategies (such as merger arbitrage and distressed credits) that the firm seesaws between. In a merger arbitrage/distressed credits traditional nondirectional model, the firm runs between 80 percent and 90 percent in one of those strategies, depending on where the market is in the cycle between merger arbitrage and distressed credit. When the seesaw moves, the firm goes 80 percent or 90 percent the other way. Unfortunately, a large portion of Wall Street looks at what happened last time and assumes that environment will be the “norm” going forward. Furthermore, any deviation from the “norm” is seen as abnormal. So, in the late 1980s, a number of firms were very concentrated in merger arbitrage. But then the world changed, and merger arbitrage opportunities dried up. At the same time, a substantial amount of investing became available in distressed credits. As the environment changed, some firms did an incredibly good job in shifting. Some accomplished the shift by planning well in advance and being ready. Others, quite frankly, had not planned in advance but still managed to pull off the transition well. Then, the seesaw reversed. In the 1993–94 time frame, the economy recovered and another shift occurred that brought about a huge wave of mergers and restructurings that lasted from 1994 until 2000. Meanwhile, little opportunity existed for investing in distressed credits. Then, the economy weakened, and the environment shifted the other direction, back toward distressed credits. Now that the economy appears to be doing better and recovering, I expect that the seesaw will move again. The opportunities in distressed credits have ©2004, CFA Institute • cfa pubs.org

been dissipating, and a pickup is expected in merger arbitrage. Our view at Och-Ziff, however, has been that in this cycle when merger arbitrage picks up, it is not going to approach anywhere near the levels of opportunity seen in the last cycle. That forecast is not a comment necessarily on the level of activity, on the size of the deals, or on the number of bidders. Rather, it is a comment on the spreads that will exist on the transactions. If spreads are not going to be at the levels seen in the last cycle, then the concept of moving 70, 80, or 90 percent of a portfolio into U.S. merger arbitrage will be a bad decision. More important, a majority of those who run the traditional model will not be prepared for that shift. Och-Ziff Model. Our model at Och-Ziff is a little bit different. For example, we do not exceed a roughly 40 percent allocation to a sector. We have two reasons for making that decision. First, no matter how great a sector looks, no matter how incredible the opportunity looks, we know how easy it is to be wrong. Second, we believe that if a firm has 80 percent of its assets in one sector for a multiyear period, it will lose the other businesses. It does not matter how well the people in this other sector are paid. If, for example, a firm has an office in London with virtually no capital invested there, the firm will not be on the phone with the London office every day talking about positions that it does not put in the portfolio. The firm will not be dedicating resources to the London office, and it will not be making sure that staff in the home office travel to the London office and integrate. In the true multistrategy world that we think exists today, however, maintaining those investments is important. Moreover, it is a difficult thing to fix after the fact. In essence, well-run firms do not consider themselves to be merger arbitrageurs, distressed credit investors, or convertible arbitrageurs. Rather, they consider themselves to be investors with an expertise in these different disciplines and a willingness to allocate capital appropriately. Well-run nondirectional, multistrategy firms have understood this notion for some time and have set up their businesses accordingly. Evolution. Evolution is important. It is a specific term that I chose in contrast to “style drift,” which is at the opposite end of the spectrum. Intelligent, wellplanned evolution of a strategy can be a good thing. Style drift, in my opinion, is automatically a bad thing. It does not matter if the manager gets lucky and generates a good return; I consider style drift to be a bad thing. Style drift is about chasing the hot sector. In contrast, evolution of a strategy is something that is planned by managers in advance after considering CFA Institute Conference Proceedings • 11


where opportunities will develop and where managers should have an edge in focusing on those opportunities. It takes factors such as expertise, personnel, strategy, and risk management into consideration. More important, evolution takes into consideration how managers can maintain control while allowing the firm and its people to grow.

Difficulties and Opportunities Ahead In hindsight, 2003 was generally a good year for hedge funds. The market itself presented significant opportunities, and the distressed credit market in particular was able to capitalize on those opportunities. A number of macro trends also allowed some hedge fund managers to excel. The question now is: What can investors expect going forward, and what issues still exist? In 2002 and 2003, a lot of managers talked about the fact that interest rates were very low, growth was very low, and risk and uncertainty in the world were very high. A lot of money came into hedge funds, making the environment that much more competitive. As money continues flowing into hedge funds, the additional competition will make successful investing more difficult. Truthfully, over the past 20 years, I have seen the industry get more competitive and harder every year. A prime example of how the difficulties manifest themselves is with merger arbitrage, which is really a business of lists. No matter how good a manager is, everyone gets the same list every day. Every manager is capable of picking up the phone, calling Bear, Stearns & Company, and obtaining a list of every merger arbitrage opportunity it has and the spreads on each deal. If the spreads are trading at a level that is too tight, managers cannot mandate that they trade at wider spreads and create an opportunity. So, a particular manager can be better at selecting deals, but all managers have to remember that everyone has access to the same deal list. Fortunately, although competition among hedge funds is fierce, some new opportunities do exist. An area where Och-Ziff is focused is what we call “mak-


ing sure that we are on two lists.” The first list we want to be on is the short list of firms that are called to help with complex financial problems that require flexible capital. The following example will illustrate what I mean. What if the Dutch government wants to sell $2 billion worth of Royal KPN N.V. (KPN) and it wants to do it tomorrow, but the Dutch government cannot sell KPN for tax, regulatory, or other reasons. The government can, however, sell a security that will become KPN in six months, which is effectively a derivative of KPN. A mutual fund with a mandate to be long stocks listed on certain exchanges cannot buy it. But a hedge fund with total flexibility can. Moreover, a hedge fund could set up an arbitrage and short KPN against the derivative security. The key is to be one of the three, four, or five firms that get those kinds of calls. The second list is what I call the “obvious list.” Here, I am referring to the firms that get the call to be part of an investment group. Many of these deals are almost no-brainers. Getting into that group requires developing two-way relationships with investment banks, corporations, leveraged buy-out firms, individual investors, and deal brokers. Getting into this group takes a long time and a lot of work, but in a highly competitive environment, it is an important area for maintaining opportunities.

Summary In looking for opportunities, the first thing an absolute-return manager has to do is acknowledge that operating in this environment successfully is going to be harder going forward than it has been traditionally, largely because of the increased level of competition in some of the businesses in which absolute-return managers are active. Success will come to those firms that stay within their core businesses and stick with their investment mandates but that strive to evolve as the world evolves. Firms that can evolve with a solid plan are those most likely to succeed. Moreover, the ability to evolve is what investors should truly be watching for as they evaluate hedge fund firms.


Q&A: Asness and Och

Question and Answer Session Clifford S. Asness Dan Och Question: Is there a way for hedge funds to convince their investors that the performance part of fees is more important than the fixed fees? Asness: An extreme view might be that the fixed fee should be just enough to pay for the hedge fund’s expenses. In that instance, the manager would only make money when the hedge fund produces a return. If you view the world as all alpha, a pure performance fee on alpha might make sense. But to the extent you view the hedge fund world as also providing some beta exposure, it makes almost no sense. So, the fixed fee aspect comes from simply executing the strategy as agreed upon. The performance fee comes into play to the extent that a manager believes that he or she can deliver superior returns versus other managers. I cannot say exactly what the right split should be, but I think that the performance fee/fixed fee framework is the best starting point. The fixed fee comes in to the extent that a manager is providing exposure to a strategy. The performance fee is added in proportion to the extra value that the manager can deliver. So, I like the split into both fees, but I think performance fees should start to move to being net of hedge fund “beta.” Och: I would answer that question slightly differently. How do you make sure that the interests of the manager, the other hedge fund partners, and the hedge fund employees are all aligned with the investors’ interests? I don’t think there is a magic formula or mix for fees. I think any formula is fine as long as it addresses that question satisfactorily. ©2004, CFA Institute • cfa pubs.org

Question: Could you give some examples of the worst types of style drift? Och: First, something that should clearly bother the investor regardless of whether it works is a change that the investor was not told about. I think that situation is unacceptable, period. End of discussion. Second, if the manager or the risk control system and process that you assume were in place were not actually monitoring what was being done and what was going on, that is absolutely unacceptable from a business point of view. Third, and I think this is the most important, if the amount of risk and types of risk are substantially different from the investor’s expectations, that is totally unacceptable. Let me differentiate between evolution and style drift with an example. If a manager puts 2 percent of the portfolio in statistical arbitrage as part of what the manager calls an evolution, I think the manager can fairly argue that he or she is planting a seed in hopes of growing something in the future. In other words, the time and resources spent in exploring the alternative are a fair balance with the potential future benefit. Compare that situation with what was probably the most egregious example of style drift ever—Russian bonds. A large number of firms were holding Russian bonds when they collapsed. Those firms had no business owning Russian bonds. In many cases, they held the bonds as a result of increased risk tolerance in search of higher returns.

Asness: A similar thing happened in 1994 when a lot of managers who had established themselves as stock pickers were suddenly doing the European bond conversion trade. Just because a lot of other smart people seem to be doing it, it doesn’t mean it is a great reason to give it a shot. That is style drift, not evolution. Question: Can you comment on what seems to be a small trend of charging reduced performance fees below high watermarks? Och: I think what these firms are doing is being done with the right intent. It remains to be seen if investors will like it or not. I don’t know the exact terms, but I believe these firms have proposed a system in which they are paid a reduced incentive if they lose money and will stay with the reduced compensation level until they achieve a certain premium. Ultimately, I would worry about the firm losing some of its best people if it loses too much in a tough year and the watermark is too high. My firm is not considering making any changes at this point. We’re going to wait. If our investors come to us seeking a change like this, then we might be amenable, but at this point, we are not planning to make such a change. Asness: I assume you mean the structure where a smaller performance fee is imposed under the high watermark but it is made back after you reach the high watermark and go up more, right? We have also not made this change at my firm, and we are not planning to. But it is interesting.



I would even go a step further and say that you do not want people to fear losses so much. A hedge fund manager is being paid to take calculated, planned risks. You don’t want to create a situation where the manager may have difficulty properly executing the investment strategy because of risks. Finally, if the investor has a long-term perspective and if the investor thinks the manager is a good manager who will eventually come back, then it really doesn’t matter much. And if you think returns are never coming back, you probably shouldn’t be staying! Question: If you were to manage half the assets you have today, what do you believe the impact would be on your performance? Asness: Positive. You are not being honest if you don’t admit that there is a curve. On the x-axis is assets under management, and on the y-axis is the achievable Sharpe ratio. There are arguments that adding assets helps build the resources to where a manager can buy the right teams and abilities. But that becomes a weak argument after a certain point. In other words, once you get past a certain point, additional assets begin reducing achievable performance. I think it is just dishonest to say that the difference between $2 billion, $5 billion, and $10 billion is not a drop in the Sharpe ratio. Ultimately, we have tried very hard to be on a gradual part of that slope. Being a multistrategy fund, our strategies have different capacities. We have been fairly aggressive at limiting the growth. In fact, in some cases, we have closed a fund that does all the strategies and have sometimes closed subfunds that do some of the lower-capacity strategies. When we start other

funds, we are honest with our clients. Although we think they can still do well, the Sharpe ratio cannot be the same. Question: Given the trend toward specialized areas of expertise, how do you train people who can evolve in a multistrategy firm? Och: During the 1980s and early 1990s, I spent 11 years at Goldman Sachs & Company where I learned how important it is to hire and train the smartest people you can find and then retain them. There is something else, which is subtle, but important and rare. You have to make sure everyone in your firm knows that if he or she is supervising three junior people and two years later the three junior people are all contributing more, then that supervisor will be rewarded for creating these winners, not told “thanks very much but we don’t need you anymore.” You must train people in your framework and methodology. If you took 15 of our investment professionals aside and asked each one “what kind of questions would Dan Och ask for each of these scenarios, what would he think the risks would be, and what would his approach be like?” I think they would all give the same answer. If you then said, “What would your approach be, and what do you think we should do?” you would get some different answers. Finally, and most important, if they were asked what would happen if they disagreed with me, the answer would be, “If I disagree with him, then I have to get right in front of him. If I agree with him, he doesn’t need to hear it from me right away.” That is essential. In addition, you have to recognize that your goal has to be to hire people who are smarter than you


are and better than you are at a lot of different things. We have a lot of people at our firm who I know are better than me at what they do. They might be better than me at it because it is all they do, and they might be better than me because they were just born better at it than I am. I don’t really care. The goal is to encourage that rather than to fight that. Last, you have to create an environment of flexibility and opportunity. People are smart. If they see that when there is opportunity within the firm it is given to someone within the firm, they will decide to make a career in your firm and they will work to keep getting better because they never know when their opportunity will arise. Question: Where will the next 10 hires you make at AQR come from? Asness: This is an interesting question. I’m going to answer from the portfolio management and research side. If you looked at the operations on the other side, those have been almost exclusively lateral hires for us. The research and trading hires we’ve made have almost exclusively been undergraduates. We look for geeks who are at least interested in finance, or even better have at least studied finance a bit. The perfect candidate is an MIT computer science graduate who is auditing classes in the business school. We continually debate, and I’ll say we have not done this yet, making a more senior lateral hire. We’ve vetted a lot of different people, and we’ve debated the pros and cons. But to date, hiring the smartest undergraduates we can find has been the best strategy for us.


Distinguishing True Alpha from Beta Laurence B. Siegel Director, Investment Policy Research The Ford Foundation New York City

Portfolios can be thought of as being composed of a beta component, which is broad asset class exposure, and an alpha component, which is excess return achieved through active management. If investors are hiring active managers, presumably because they believe these managers have real skill or the ability to deliver alpha, then they ought to be sure that they are paying for true alpha and not beta. These principles are not only applicable to traditional institutional portfolios, such as defined-benefit plans and endowments, but are also relevant for nontraditional portfolios, such as hedge funds.

ill Rogers was, among other things, a legendary investor of his personal assets and the first absolute-return investor. His advice to other investors was: “Buy some good stock and hold it til it goes up, then sell it. If it don’t go up, don’t buy it.” He was kidding as usual, but a couple of generations ago many long-only managers talked like that, and they were not kidding. They said: “We are absolute-return investors. We just buy stocks that go up. We do not care what the market is doing.” Now, a new crop of people who were not born back then are saying the same thing about hedge funds. In 1964, long-only investors who imagined themselves to be absolute-return investors were set straight by Bill Sharpe when he showed statistically how to separate the policy risk (which he called “beta”) from the active risk (which he called “alpha”). His approach caught on fairly quickly, and 10 or 20 years later, most long-only managers had their tails between their legs and were quoting the alphas they had produced, not their absolute returns that included the market or index component. If their alphas were negative, then the consultants punished them by advising clients to invest with another manager. That kind of benchmarking has added a discipline to the market that it desperately needed. Without benchmarking, investors would wind up paying alpha-type fees, active fees, for the index part of the return. Given some advances in measurement, this practice can also be applied to

W


alternative investments, where the beta exposures are not quite as obvious. Skill in the investment management industry is a rare commodity. The average market participant may be an intelligent individual, but by definition, this average participant cannot beat the average. And because the average return of all market participants can be achieved at very low cost by buying an index fund, an active manager has to be better than average to add alpha. In other words, many investors are better served by investing in a passively managed index fund than by investing with an active manager and taking the risk that the manager has less skill than average and will thus have a negative alpha. In this presentation, I will try to make sense of this principle and will focus on the distinction between active or alpha risk, which is the risk taken to beat a benchmark, and policy or beta risk, which is the risk taken by merely investing in the benchmark. I will first discuss some general principles that I call the “dimensions of active management” in reference to an article I coauthored with Barton Waring.1 Then, I will discuss applying those concepts to alternative investments, such as hedge funds, because that subject is of intense interest to so many people right now. Finally, I will talk about policy implications for pension funds and other investors. 1

M. Barton Waring and Laurence B. Siegel, “The Dimensions of Active Management,” Journal of Portfolio Management (Spring 2003):35–51.



The Dimensions of Active Management Active management has three dimensions: • pure active return, which is the value added by the manager (or what should be properly called alpha); • pure active risk, which is the volatility of the pure active return; and • costs. A manager does not have absolute control over all three of these dimensions. A manager does not control return; it comes or it does not, according to how the markets perform. An element of control is associated with active risk. Costs, however, are the dimension that a manager directly controls. If a manager wants to add to his or her return, cutting active management fees would be one way of doing so, but cutting costs will not help if the costs pay for actual alpha being delivered on a consistent basis. That cost is worth the money. A Portfolio of Betas and a Portfolio of Alphas. When investment performance is considered in the three dimensions of return, risk, and cost, a number of puzzle pieces emerge. The first one is taught in business school, but people tend not to apply it: Policy risk and active risk are separable and should be separated. They should really be thought of as two distinct portfolios. One is a portfolio of betas and consumes 100 percent of the capital. It is a portfolio of exposures to various market risk factors, which can conveniently be thought of as index funds, although the investor might be able to invest in futures or exchange-traded funds (ETFs) or something other than traditional index funds. For simplicity, think of it as 100 percent of capital being consumed through bets on various index funds. The other portfolio is a self-financing portfolio of alphas. It consumes no capital. Theoretically, an investor should be able to earn alpha anywhere in any asset class through a long–short strategy that does not involve using the investor’s own capital. The portfolio of alphas should be designed based on where the investor can best earn alpha or best earn a high information ratio (IR), which is the alpha per unit of active risk taken. That mix of assets should have nothing to do with the mix of assets in the portfolio of betas, which should be structured based on the investor’s liabilities. Investing in this way may not always be practical. But the separation of alpha and beta—what is sometimes called portable alpha—is at least a sound conceptual way of thinking about one’s portfolio. Pure Alpha and Naive Alpha. When measuring alpha, differentiating between pure alpha and 16 • CFA Institute Conference Proceedings

naive alpha is important. A lot of investment managers subtract the return of the benchmark from the return of their portfolio and then call the remainder alpha. They have not made an adjustment for beta, so this approach does not demonstrate real alpha. Real alpha must be estimated from a regression. Bill Sharpe’s market model regression is similar to the capital asset pricing model (CAPM), so most people call it the CAPM regression. That is the first step. The next step is to see if any other systematic factors in the returns properly belong to the beta category rather than the alpha category. The factors that generally turn out to be meaningful are the two common style factors known as “value minus growth” and “small cap minus large cap.” If a manager adjusts for all these common factors and for the beta of the overall portfolio relative to the market, then he or she has isolated the true alpha, the pure alpha, for which active managers should be paid. All the other exposures belong in the portfolio of betas and should reap index fund–like fees. Style Boxes. Style boxes do not do a good job of categorizing managers. A growth manager who concentrates in the most rapidly growing companies, or a value manager who is more price conscious than most, will not tend to be close to the center of his or her growth or value style box. Thinking of such managers as fitting into these boxes misrepresents managers and affects the style allocations in a negative way. A much better way of thinking about managers is to use a style map that creates a continuum from growth to value, from large to small cap, from zero beta to some beta higher than 1. In this space, a manager represents a point. In other words, the manager can be anywhere on the continuum in any of these dimensions. Manager Structure Optimization. Having identified the location of each candidate manager on the style map through style analysis, one can then build a portfolio of managers through optimization. As Barton Waring and I discussed in “The Dimensions of Active Management,” building a portfolio of managers is like building a portfolio of anything: It is an optimization problem, although it is a little trickier than conventional optimization because it has two stages. One stage is for the portfolio of betas, and the other is for the portfolio of alphas. We refer to the optimization for the portfolio of alphas as “manager structure optimization.” To do that optimization, investors require estimates of expected alphas and expected active risk (or tracking error) for managers in exactly the same way they need estimates of the risk and return of the asset classes for the portfolio of betas. ©2004, CFA Institute • cfa pubs.org

Distinguishing True Alpha from Beta

Estimating Expected Alphas for Managers. Estimating expected alphas for managers can be a struggle; many people do not know how to do it. But these expected alphas are already in their portfolios. Through reverse optimization, one can easily calculate the expected alpha implied by the weight the manager has in the portfolio. So, if people do not think they can estimate expected alphas for managers, surprise—they are already doing it. Constructing the alpha estimates needed to build an efficient portfolio of managers is, without a doubt, difficult. There is no formula or recipe for estimating expected alphas. Each investor has to come up with a way to estimate those numbers, and a particular investor’s approach may not necessarily rely on quantitative methods. If an investor is going to justify holding active managers rather than index funds, however, then the investor should be able to quantify the expectation that the manager will earn alpha. If the investor can do that, then a manager structure optimizer can be used to build an optimal portfolio of managers. Barclays Global Investors has written software to perform manager structure optimization. I have experimented with the software a little bit, and it gives surprisingly neat results. Although it sounds like a mostly theoretical experiment, it is not. The software produces portfolios of managers that are plausible and not subject to the common critique that optimizers are mostly garbage-in, garbage-out machines; the output is actually useful. Two Conditions for Selecting Active Managers. As I have said, active management should not be expected to win just because it is active; it is a zero-sum game, with winners counterbalanced by losers (and that is before deducting costs). As a result, an investor has to satisfy two conditions for it to be rational to play the active management game. The first is that the investor has to believe that there are some active managers with real skill who add value other than just by chance. The second condition, which is the tougher one, is that the investor has to believe that he or she can pick these exceptional managers from a large population of managers who are mostly not exceptional. Those who meet the second condition should indeed hire active managers and might like to know what a portfolio looks like that reflects the principles I have been describing. If an investor is constrained to be long only, then the portfolio must be constructed from managers on the bottom curve in Figure 1. Managers on this curve include index funds, enhanced index funds, and traditional active funds (both concentrated and diversified). ©2004, CFA Institute • cfa pubs.org

Figure 1.

Impact of the Long-Only Constraint

Expected Alpha

Equitized Market-Neutral, Long−Short Equity Fund

Concentrated Diversified Traditional Active Traditional Active Enhanced Index Fund Index Fund

Active Risk

Note: Expected alpha is conditional on the manager having skill. Source: Barclays Global Investors.

Manager structure optimization shows that if an investor seeks alpha and is averse to active risk, the weight in traditional active managers—especially those that are concentrated—should be greatly reduced. This result comes about because the noshorting constraint hurts the IR of traditional, highactive-risk managers more than it does low-active-risk managers, such as enhanced index funds. (With the horizontal axis representing active risk and the vertical axis representing expected alpha, the IR is thus represented by the slope of the line at any given point.) That the no-shorting constraint hurts higheractive-risk managers more than low-active-risk managers requires some explanation. All managers gather information about overpriced securities, which could be used to sell securities short. If a given manager cannot sell short, the manager can still choose not to own something that is in his or her benchmark. The more securities in the portfolio, the more opportunities to take advantage of the information that would otherwise cause a manager to short a stock. Managers who have a high-active-risk portfolio have far fewer holdings and thus far fewer opportunities to take advantage of any information about overpriced stocks. Thus, the IR is lower for these managers. Investors who are allowed to sell short can choose from the portfolios on either line in Figure 1. If an investor has a high-active-risk budget, the investor’s choices might include an equitized market-neutral, long–short hedge fund. Most of the rest of the portfolio would consist of enhanced index funds, with possibly a small allocation to traditional active funds that have particularly high expected alphas. An investor with a high-active-risk budget might not have any pure index funds in his or her optimum portfolio because index funds do not have enough active risk. At a lower-active-risk budget, an investor who is allowed to sell short would build the portfolio out of CFA Institute Conference Proceedings • 17


index funds and enhanced index funds, plus potentially some of the equitized market-neutral, long– short hedge fund. Such an investor might also hold just a dollop of traditional active managers. Note that this entire analysis has been conducted as if the fees on the long–short and the long-only portfolios were the same. They are not. Investors have to calculate returns after costs, and long–short portfolios are quite aggressively priced these days.

Do Hedge Funds Charge Alpha Fees for Beta Performance? My discussion of pure active risk and return can be applied to hedge funds and other alternative investments. Foremost, keep in mind that hedge fund managers are just active managers. There is no magic. The idea that a hedge fund manager is a crazed genius who allows a few of his wealthy friends to invest in the fund if they pay 2 percent of assets and 20 percent of the profit is obsolete. Such fee levels are ridiculous for hedge funds that are large institutional investment organizations. The 2 and 20 fee structure that makes perfect sense for the genius and his friends has been scaled up, without any discounting, to apply to investments in the billions of dollars for prominent hedge funds. The hedge fund fee structure has become little more than a mechanism for transferring wealth from the investor to the manager in a way that is not possible in a traditional, long-only portfolio where the fees and the strategies are more transparent. Separating Alpha and Beta for Hedge Funds. Putting costs aside for the moment, I will discuss how an investor might apply to hedge funds my earlier comment that the dimensions of active management are pure active return, pure active risk, and costs. The pure active return is the return left over after adjusting for any beta exposures that exist within the hedge fund. Many investors are used to thinking of beta as exposure to the stock market. But a whole array of other systematic risk factors can also be considered beta. In a meeting of the Foundation Financial Officers Group in Chicago in October 2003, Clifford Asness said that if a strategy can be written down, in the sense of a recipe that anyone can follow, it is passive and it is beta; anything else is alpha. Following is a short list of potentially nonobvious beta exposures that are often found in hedge funds: • value minus growth, • duration (interest rate risk), • credit spreads, • optionality (e.g., being “short volatility”), • buying merger targets, shorting the acquirers, • buying convertible bonds, shorting the stock of the issuer, 18 • CFA Institute Conference Proceedings

•

borrowing short, lending long when the yield curve is steep (carry trade), and • borrowing in one currency, lending in another (international carry trade). Clearly, a lot of market-type exposures are inherent in hedge fund strategies. Although index funds may not exist for these market factors, the systematic strategy can be identified and written down. In principle, investors are paying 2 and 20 for a package deal that includes both true alpha, which is the return above and beyond any returns from these systematic strategies, and a significant beta component. Getting 2 and 20 for the index part is nice work if a manager can get it. Clifford Asness said something else very clever at the Chicago meeting: Alpha becomes beta over time once the source is discovered and promulgated. What is he talking about? Well, the first person to discover the return potential of value minus growth should be insulted to hear it called a beta factor because that person could have made a huge amount of money and nobody would have been able to determine where it was coming from. But now that everybody knows about it, it is beta. Not only can it be written down; it can be bought at very low cost using index funds or ETFs. Thus, to deserve the 2 and 20 fee structure, the hedge fund must be able to add alpha beyond merely being long in value and short in growth. Hence, alpha became beta over time. I am not completely comfortable classifying anything that can be written down as beta. I think investors need to be able to “buy” a market factor through long and/or short positions in index funds, ETFs, futures, options, or swaps for it to be beta. Sometimes, investors have to pay alpha-like fees for exotic betas that are not yet available through lower-cost vehicles. I suspect that much of the success and popularity of hedge funds comes from their ability to sell exotic beta rather than from pure alpha as Asness stringently defines it. Identifying Hedge Fund Betas: A Study. Bridgewater Associates conducted a wonderful study that sought to differentiate alpha from beta for hedge funds. Results for fixed-income arbitrage hedge funds are shown in Figure 2. The dotted line represents six-month rolling returns of an index of fixed-income arbitrage hedge funds. The solid line is a model that Bridgewater devised that fits the managers’ performance pretty closely. The alpha is the area created by geometrically subtracting the dotted line from the solid line. Beta is the extent to which the two lines zig and zag together. So, this figure presents a sort of visual returns-based style analysis. The correlation of the model with the managers is 59 percent, which is ©2004, CFA Institute • cfa pubs.org


Figure 2.

Fixed-Income Arbitrage Six-Month Rolling Returns, June 1990– June 2003

Six-Month Return above Cash (%) 15 Fixed-Income Arbitrage Model 10 5 0 −5 −10

CSFB/Tremont FixedIncome Arbitrage Index

−15 6/90 6/91 6/92 6/93 6/94 6/95 6/96 6/97 6/98 6/99 6/00 6/01 6/02 6/03 Note: The fixed-income arbitrage model consists of a 15 percent weight in the Eurodollar over Treasury spread, 5 percent in the emerging market debt spread over comparable-maturity U.S. Treasuries, 35 percent in the U.S. corporate bond spread over Treasuries, and 50 percent in the U.S. mortgage spread over Treasuries. Source: Based on data from Bridgewater Associates.

pretty good considering that the managers typically claim they are absolute-return managers with no beta exposures. The important thing to note about this figure is how little space is between the dotted line and the solid line. In other words, these hedge fund managers produced very little alpha. The results for emerging market hedge funds are shown in Figure 3. For this strategy, the Bridgewater model had a remarkable correlation of 81 percent,

Figure 3.

which corresponds to an R2 of 65 percent. That is, 65 percent of the variation in these supposedly beta-free funds was explained by beta factors. Again, there is very little space between the solid line and the dotted line. There is a little alpha, but not very much. Managed futures fund results are shown in Figure 4. The model had a correlation of 75 percent and, once again, a very high R2. The model spends a significant amount of time ahead of the average manager.

Emerging Market Six-Month Rolling Returns, June 1990– June 2003

Six-Month Return above Cash (%) 50 40 30

CSFB/Tremont Emerging Markets Index

20 10 0 −10 −20 −30 −40

Emerging Markets Model

−50 6/90 6/91 6/92 6/93 6/94 6/95 6/96 6/97 6/98 6/99 6/00 6/01 6/02 6/03 Note: The emerging markets model is an equally weighted combination of emerging market debt and emerging market equity indexes. Source: Based on data from Bridgewater Associates.




Figure 4. Managed Futures Six-Month Rolling Returns, July 1996–July 2003 Six-Month Return above Cash (%) 40 Managed Futures Model 30 20 10 0 −10 −20 7/96

CSFB/Tremont Managed Futures Index 7/97

7/98

7/99

7/00

7/01

7/02

7/03

Notes: The managed futures model consists of a “1 × 3 month” momentum strategy in which one buys a given market if the one-month moving average is above the three-month moving average or sells if below. This strategy is followed on an equal-weighted basis across each of the following markets: the euro, yen, U.S. 10-year Treasury bond, S&P 500, and the Eurodollar six-month maturity return above cash. Source: Based on data from Bridgewater Associates.

In this case, it appears that active management subtracted alpha. The model consisted of a series of momentum trades, but one could build an index fund using these trades if one so desired, although I do not think any such index funds currently exist. Finally, merger arbitrage fund results are shown in Figure 5. The model was just the return on the S&P 500 Index, with an adjustment made for the

number of merger and acquisition deals that were available to invest in. Considering how simple the model is, the tracking between it and the hedge funds’ returns is fairly high, with a correlation of 52 percent. But the area between the solid line and the dotted line is substantial. Active managers made a lot more money than would have been achieved by investing in the model.

Figure 5. Merger Arbitrage Six-Month Rolling Returns, June 1990–June 2003 Six-Month Return above Cash (%) 15 10

HFRI Merger Arbitrage Index

Merger Arbitrage Model

5 0 −5 −10 6/90 6/91 6/92 6/93 6/94 6/95 6/96 6/97 6/98 6/99 6/00 6/01 6/02 6/03 Note: The merger arbitrage model uses the six-month return above cash of the S&P 500, multiplied by a beta (between zero and one) proportional to the number of merger deals available in the market at each point in time. Source: Based on data from Bridgewater Associates.




Policy Implications for Pension Funds and Other Investors Every pool of assets has been accumulated for some reason. Usually, the assets exist to pay for an actual contracted liability or for a conceptual liability, such as retirement. Fortunately, people are catching on to the idea that the liability is really the ultimate benchmark. If an individual earns a return on his or her accumulated savings that is high enough to maintain his or her lifestyle in retirement, or if a plan sponsor is fully funded relative to its economically determined pension liability, or if the Ford Foundation earns a rate of return high enough to make the grants that it was established to make, then all three have achieved their investment goals. Foundations. At the Ford Foundation, we have only one problem with that definition of success. Our liability (we are required to pay out annually 5.3 percent of whatever our asset value is at the time) makes us absolute-return investors in principle. But we do not know how to develop an asset allocation policy that has an expected return of 5.3 percent plus the inflation rate (to keep the purchasing power of the portfolio whole). We have to build the policy portfolio out of asset classes that exist. Our estimate for the expected real return on stocks is about 5 percent. Nominal bonds, TIPS (the common name for U.S. Treasury Inflation-Indexed Securities), real estate, cash, and other assets have even lower expected returns. Truly hedged hedge funds, if we held them, would have a zero beta and, for the purpose of calculating their expected return, the benchmark should be the return on cash. Of course, if we thought these funds were going to earn only the cash return, we would not buy them; we would hold cash instead. But any return offered by hedge funds beyond the return on the cash benchmark is alpha, and one should never put alpha into the expected return on a benchmark or policy portfolio. The policy portfolio should consist only of betas, and the production of alpha can then be measured relative to this purely beta-driven benchmark. So, to answer the question of whether there should be a policy portfolio for an institution with an absolute-return payout requirement, the answer is that we do need one, and it should be built out of assets for which index funds exist. Ours happens to be constructed from indexes of U.S. and international equities, nominal bonds, TIPS, and cash. We can then judge the success of our active asset allocation decisions by reference to this policy portfolio. Of course, we can ©2004, CFA Institute • cfa pubs.org

change the policy portfolio when we believe it is prudent to do so. There is no reason that it should be static, although changing it all the time would tend to blur the distinction between active and policy decisions. We can also compare our performance with that of a hypothetical asset that returns 5.3 percent plus the inflation rate. But if we decide that we are unable to add alpha, we cannot index the portfolio instead and earn this rate of return. That is why an absolutereturn benchmark does not make a lot of sense. Defined-Benefit Pension Plans. Definedbenefit pension plans have a special set of challenges because the size of the liabilities is set in a process that has nothing to do with the size of the assets. Although a foundation’s liabilities are linked to the assets by a simple formula, in a pension plan, the liabilities are set by contracting with the workers without reference to what assets may be available to pay the pension benefits. It is then the sponsor’s problem to accumulate enough assets through a mix of pension contributions and investment returns. To minimize required contributions from the sponsor, many pension plans have adopted very high equity allocations, 70 percent or more. But such an allocation creates a great deal of risk in the pension plan because the pension liabilities look more like a portfolio of nominal bonds and TIPS with only a little in equities. Pension plans should thus consider lowering their equity allocations. Looked at another way, a pension plan is just a project of the sponsoring corporation. If investing in the S&P 500 is such a great proposition, why not shut down the factory, sell the assets, and just buy shares of the S&P 500 to increase the productivity of the company’s capital? The fact that no company ever does that shows companies do not think investing in the S&P 500 is such a great corporate project. Some people wonder whether a broad shift among pension plans toward a closer match of assets and liabilities would cause the market to decline. If all pension funds decided at once that they needed to sell equities and get to a position that more closely matched their liabilities, who would be buying the equities? The answer is that the investors who hold the shares in these corporations would suddenly find out that they are short in beta because the companies themselves in which they hold stock no longer have a leveraged position in the S&P 500. So, to keep their risk level the same and the reward for taking the risk the same, they would have to buy the equities that the pension funds would be selling. In the short run, any change in the supply and demand for an asset produces volatility. But in the long run, it would not change the overall price level of the market. CFA Institute Conference Proceedings • 21


Stated another way, if companies that have a bet on the S&P 500 in their pension funds are currently fairly priced and they then unwind this bet, the risk of the companies must go down but not the expected return, so the stocks will be self-evidently a bargain and investors will buy them. Defined-Contribution Plans and Individual Investing. The defined-contribution world, which is a subset of individual investing, has been poorly served by the financial system because it sells plan participants high-cost products that produce negative alpha, on average, even before fees. Furthermore, investors do not understand the efficient frontier or how to build an optimal portfolio. Every worker— every airline pilot, every nurse, and every tort


lawyer—has gotten roped into the position of being a chief investment officer for his or her own assets. These workers never asked for this responsibility and have never claimed they were good at it; by and large, they are not. Why not just do it for them? If they could invest in a well-engineered, optimized portfolio consisting mostly of index funds but with some active funds mixed in that are carefully chosen by the sponsor, they would have a lot more money for their retirement and they would be earning it with a lot less risk. In other words, we should be working hard to try to get the principles that I just discussed, which are gaining currency in the world of institutional investing, applied to individuals’ investments too.


Q&A: Siegel

Question and Answer Session Laurence B. Siegel Question: Why does the Ford Foundation hire only long-only managers? Siegel: The Ford Foundation Investment Policies and Guidelines, which are voted on by our board of trustees, say that we are not allowed to sell short. Consequently, we cannot invest in most hedge funds. That decision can be changed by a vote of the trustees, but it has not happened yet. Question: Do you construct complicated benchmarks based on indexes? Or, do you compare your performance with that of other big foundations? Siegel: The proper benchmark for an active portfolio is a holdable passive alternative that can be achieved at low cost (i.e., an index fund or portfolio of index funds). So, we not only construct a benchmark, or policy portfolio, but we also make sure that we could hold that benchmark if we so choose. Our benchmark is not particularly complicated in that it consists of only four assets (five if you count nominal bonds and TIPS separately). It is interesting and informative to know how well other big foundations are doing. We can learn from them, and we can find out if we are falling short in some way. But they’re not our benchmark because they may have different institutional constraints, risk preferences, or investment objectives. For example, most institutions are allowed to invest in hedge funds; at present, we are not. A pension fund has a certain set of contractual liabilities, so it may hold long-duration bonds whereas we hold shorter-duration bonds. So, they’re not our true peers. ©2004, CFA Institute • cfa pubs.org

Ultimately, for a benchmark, we want a list of securities and weights that could be held by purchasing an index fund. Question: The new hedge fund benchmarks are getting a lot of attention, and some of the products being created are attracting a lot of capital. Could you comment on these? Siegel: Many hedge fund benchmarks have been constructed specifically to raise capital and not just to provide a point of comparison for other portfolios. This situation creates a conflict of interest. If you are creating a benchmark because you want to start an index fund that will attract as much capital as possible, you might try to pick the winners because you want your customers to prosper. If you are constructing a benchmark as a point of objective reference for performance evaluation for existing portfolios, you presumably would not have that bias. Traditional benchmarks, such as the Dow Jones and S&P 500, were created by newspapers and financial rating firms, which didn’t have customers who had a stake in the outcome. I think that many of the existing hedge fund benchmarks have been built quite diligently. And in the hedge fund world, where there were no standards of performance until recently, the new benchmarks represent the first generation of quantifiable standards. Thus, they are useful tools. But if there is no attempt to pick the winners, why would you want to invest in the benchmark? The answer might involve regulatory arbitrage. Certain types of institutions, such as banks and insurance companies, can’t invest directly in hedge funds but can

invest in structured securities that are linked to the return on a hedge fund index. So, that is an extra reason for creating some of these benchmarks, beyond creating performance standards. Question: If value minus growth becomes beta, will the chance of earning alpha for value minus growth disappear? Siegel: Market theory says all stocks are fairly priced. When that happens, the chance for all alpha disappears. I don’t see it. If the market is getting more efficient, I am a monkey’s uncle. I don’t think that there is the slightest chance that the opportunity for alpha is going to go away, but it may get a little harder to find, and it may mutate a little bit. The past 40 years show that value minus growth is the most powerful effect in financial markets. I don’t know for sure that it is going to persist, but I’m betting on it. It seems to me like it is a beta exposure with a high expected payoff. The reason is probably behavioral. Value stocks tend to be stocks of companies that have some terrible faults, and investors don’t want to be caught dead with them. Growth stocks seem to be stocks of companies that everybody wants to own. So, there is slack demand for the value stocks, raising their expected return per unit of risk. And there is excess demand for growth stocks, lowering their expected return per unit of risk. Sometimes, this effect will turn around and run in reverse, with growth outperforming value for long periods. So, I would hold a diversified portfolio of styles but with a value bias, on average, over time.


Solving the Investor’s Problem Kevin Kneafsey Senior Investment Strategist Barclays Global Investors San Francisco

The sinking asset values and falling interest rates of 2000–2002 demonstrated the need for managers to take a new approach to help investors reach their goals. Managers can do a better job of building a policy portfolio that truly hedges the liability that needs to be funded. Moreover, managers can help pay for that hedge if they also build a growth portfolio that allocates capital in proportion to how efficiently each return source produces return. This growth portfolio also allows investors to accept only the beta exposure that is appropriate while porting alpha from places where it is most prevalent and easy to capture.

very investor faces the same general problem, whether the investor is a 16-year-old teenager saving for a car, a middle-aged couple saving for retirement, or a pension plan funding its future outflows. And that general problem is how best to set aside current assets to fund some future cash flow, which can be thought of as a liability.1 Every investor has to determine how much he or she needs to save and how best to invest that money to fund that liability. The problem is very general, and I want to address it on those terms. I do not want to narrow it down to one specific application because the same message rings true whether I am talking about retail clients, pension funds, or endowments. In this presentation, I will first discuss the current approach to solving the investor’s problem. Then, I will address the lessons investment managers learned (or should have learned) over the past several years. Those lessons point to a different way of getting at and solving the investor’s problem.

E

Current Approach Currently, solving the investor’s problem is a threestep approach. First, the liability must be defined. How much is this car going to cost the 16-year-old teenager? How much money will the couple need to live comfortably in retirement? What is the pension 1 I would like to acknowledge that I became interested in formally

addressing this topic in response to Peter Bernstein’s article “Are Policy Portfolios Obsolete?” in Economics and Portfolio Strategy (1 March 2003).


fund’s liability structure? In each case, the investor needs to construct and analyze the series of cash flows necessary to meet the investor’s goal. The second step is to determine the “best” mix of assets. Peter Bernstein calls this mix the “policy portfolio.” It is the base allocation among broad asset classes—stocks, bonds, domestic, international, and so on. This mix is determined by selecting a combination of assets that has the best risk–return trade-off and that is likely to accomplish the investor’s goal. The last step is to populate the policy portfolio. Having determined what mix of assets to use, the manager now determines which investment managers, whether active or passive, should be used to fill each asset bucket in the policy portfolio mix.

Lessons of 2000–2002 Although the current approach certainly sounds sensible, I believe managers can draw on some experiences over the past few years that call attention to the need for an alternative way of approaching the investor’s problem. I will start with a look at U.S. state pension plans, as shown in Figure 1. For this graph, I decided to focus on 2000–2002. The year 2003 turned out to be a wonderful year, thanks to the comeback in equities, but 2003 was potentially a dangerous year. A look at 2000–2002 will illustrate why. Back in the beginning of 2000, the average state plan was overfunded and had more than enough assets to cover its liabilities. That same year, only about 20 percent of state plans were underfunded.


Solving the Investor’s Problem

Figure 1.

Funded Status of State Plans, 2000–2002

Funded Status (%) 120 100 80 60 40 20 0 2000

2001

2002

Assets as Percentage of Liabilities for the Average Plan Percentage of Plans Underfunded Source: Based on data from Wilshire Associates.

Compare that situation with 2002. By 2002, plans had slipped from being comfortably overfunded to being significantly underfunded. Additionally, the proportion of plans that were underfunded grew to be the vast majority. That is a remarkable change in just three years. Imagine how dangerous the situation would have become in 2003 if the equity market had not rebounded. Two things happened between 2000 and 2002 to drive the trend toward underfunded plans. First, asset values fell. Second, falling interest rates pushed up the present value of plan liabilities. As Figure 2 illustrates, the poor performance of equities coupled with the growing value of liabilities created a huge chasm. Based on this historical context, managers should have learned two lessons.

Figure 2.

Lesson One: Long-Run Forecasts Are Guesses. As Peter Bernstein pointed out in his March 2003 article, long-run forecasts are generally not reliable. Consequently, the foundation on which managers are building portfolios is shaky. Constructing portfolios starts with the broad asset class decision—how much of the policy portfolio is allocated to equities versus fixed income. The first step in making that allocation decision is to derive a long-run forecast for the equity risk premium (ERP), which is the expected spread between equity and bond performance. The volatility of that spread between equities and fixed income is about 16 percent a year. If that 16 percent annual risk is rolled into a 10-year period, the risk for the decade is approximately 5 percent. By plotting that 5 percent risk on a normal distribution, one will find only a 20 percent chance of being within 1.25 percent of this expected ERP. Let me put those numbers in perspective. The allocation to equities versus fixed income is one of the biggest drivers of portfolio performance. For every 1.25 percent that the forecast varies from the actual ERP, the allocation of equities versus bonds will be off by about 10 percent. So, the manager has only a 20 percent chance of being within 1.25 percent of the right ERP and an 80 percent chance that his or her allocation to equities versus fixed income will be off by more than 10 percent. Lesson Two: The Short Run Matters. If the first lesson that long-run forecasts are guesses seems disheartening, then the second lesson might seem even more so: The investment horizon is much shorter than the duration of the plan. That is, in spite

Cumulative Stock and Bond Returns, December 1999– December 2002

Cumulative Return (%) 60 Lehman 20+ Year Treasury Bond Index

40 20 0 −20

S&P 500 Index

−40 −60 12/99 3/00

6/00


9/00 12/00 3/01

6/01

9/01 12/01 3/02

6/02

9/02 12/02



of a long-duration liability, the short run matters. Consider the three alternatives depicted in Figure 3. The solid line “A” represents a hypothetical investment that provides consistent cumulative performance over 10 years. The investment represented by the dotted line loses money during the first five years but performs well enough over the second five years to ultimately produce the same cumulative return as “A.” Last, the dashed line “C” is very volatile compared with “A” and “B,” but ultimately, it provides the same cumulative return. All three alternatives end at the same place. If you were Rip Van Winkle and you slept for the 10 years, it would not matter what happened during the interim period as long as you ended up in the same place. The three alternatives could just as easily have been the same investment over three different 10-year horizons. In each case, the investment may have been prudently considered with a disciplined, long-term approach. But even if a manager approaches the market with a long-term view, tremendous pressure is exerted by shorter-term performance. Regardless of whether a manager is investing for an individual with 20 years to retirement, a pension plan with a 15-year duration, or an endowment with infinite duration, the manager is exposed to the short run, and it matters. For example, a lot of plans were scrambling in 2003 because of what happened over the previous three years. They thought their investment horizon was measured in decades, but a three-year stretch suddenly resulted in turning the whole boat Figure 3.

around. In short, the investment horizon is shorter than the duration of the liability the plan is trying to fund, and thus, consistency matters.

Superior Approach The policy portfolio that is built by using the current approach wears two hats: It tries to hedge the liability a bit, but it also tries to generate more return above the liability. In this section, I am proposing an alternative framework for solving the investor’s problem. Ultimately, this framework will help address the two concerns I have raised regarding long-run forecasts and managers’ exposure to the short run. Steps in the New Framework. In this framework, I am advocating the use of a policy portfolio that does one thing—hedge the liability. Sources of growth are then sought out independently. Following are the steps that need to be taken in this superior approach. ■ 1. Define the liability. The first step is to define the liability in the same fashion that it is done in the current approach. Because this first step is the same for both approaches, I will not offer additional guidance here. And although it is an important topic, it is best reserved for a separate discussion. ■ 2. Construct the policy portfolio. The second step, just as in the current approach, is to build a policy portfolio. But this time I go about it differently. Within this new framework, the only thing I am striving to accomplish at this point is to hedge the liability.

Hypothetical Cumulative Returns

Return (%) 200

150

100 A 50

C

0 B −50 −100 0

1

2

3

4

5

6

7

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The purpose of this hedge is to avoid exposing the portfolio to a situation such as the one that occurred from 2000 to 2002, when asset values and liabilities moved radically in different directions. Because I am hedging something with the characteristics of a liability, the hedge portfolio in most cases will tend to look very bond-like. Furthermore, this hedge helps to lessen the problem of the unreliability of long-run forecasts. Because the hedge portfolio looks like the liability stream I am trying to hedge, both are susceptible to the same longrun forecast. Forecast errors on the asset side and the liability side thus tend to offset each other much more than when the asset base looks different from the liability. In short, the portfolio is less exposed to longrun forecast errors. ■ 3. Build a growth portfolio. In step two, a hedging portfolio is set up to immunize the future expense, whether it is an individual’s retirement or a pension liability. That hedging strategy can be very expensive (in terms of how much needs to be saved), so to lower this hedging cost, a growth portfolio is built to maximize the return per unit of risk. To accomplish this task, investment products must be found that add alpha relative to their benchmarks (irrespective of the policy mix) or that add beta relative to the liability. The goal is to close the gap between the required return and that provided by the liability hedge using the most efficient sources of return, where efficiency is measured in terms of return per unit of risk. ■ 4. Neutralize undesired beta exposure. At this time, I want to point out that any bet that differs from what that liability portfolio looks like is an active bet. When I refer to beta, I am talking about benchmark exposure or exposure that is not pure alpha. Alpha is pure absolute return that is neutral to general market risk factors, such as interest rates. No reason exists to accept the beta that comes with any particular source of alpha unless the investor is interested in making an active bet with a beta tilt. By neutralizing unwanted beta, the investor can keep the alpha while maintaining only the beta in the asset classes and in the proportions that are appropriate for the portfolio. This step separates alpha from beta and allows alpha sources to be sought out irrespective of their associated beta. Improved Consistency. One of the goals of this new approach is to improve consistency. And to that end, I am trying to build a hedge portfolio that looks like the liability and that avoids the double whammy that occurred in 2000–2002. Think about that hedge portfolio. To construct it, I will have to make some long-run forecasts. What sort of cash flows are in the liabilities? What is going to pay those cash flows? The hedge portfolio looks a lot like the liability stream I am trying to hedge; they are both susceptible to the ©2004, CFA Institute • cfa pubs.org

same long-run forecast. So, if I made a bad forecast of inflation, I made a bad forecast on the asset side and the liability side. They will tend to mitigate each other much more than they do when the asset base looks different from the liability. That is, the portfolio is less exposed to long-run forecasts. In the fourth step, building the growth portfolio, I move the overall portfolio into a world where alpha return above some benchmark is independent of the beta that might come with it. Let me give an example. If you are a large-cap U.S. manager, you are trying to beat the S&P 500 Index. Beta is your S&P 500 exposure. Your alpha is what you can do above that beta exposure without adding market risk (systematic). It is not just a levered tilt on equities. Beta will sweep away all your exposure to the S&P 500; anything you do above that is actually the alpha that you generate. When I talk about separating alpha from beta, what does that mean? Let me stay with the same simple example. Suppose now you are an investor and you find a U.S. large-cap manager who you like. How do you separate alpha from beta? You can invest in that manager and sell futures on the S&P 500 to eliminate the manager’s beta exposure. What are you left with? Just the manager’s alpha. And now that the alpha has been separated, it can be ported anywhere within your portfolio. No reason exists to think that just because you like a manager you have to take his or her beta also. The rare commodity you are buying is alpha; beta is a true commodity, and you can get it anywhere and very cheaply. What you spend your money on is alpha. Do not restrict yourself in seeking alpha sources by linking alpha to the beta that comes with it. Finally, managers need to be optimized at the plan level. A typical pension plan that wants to build the best international exposure it can examines what its international managers look like relative to each other. The fact is the amount of capital that can be allocated to international managers is restricted by what is in the policy portfolio—10 percent, 15 percent, 20 percent. Most investors think they can get a lot more alpha from international investing than they can from large-cap domestic and a lot more alpha from small-cap domestic than from large-cap domestic. But how they allocate capital is perverse to that thinking. Investors should allocate a lot more capital to areas where they see alpha more prevalent and then get the beta exposure they want by unwinding the beta exposure of the managers they bought (i.e., buying the beta exposure that they want in their policy portfolio, which might be large-cap domestic, and selling beta they do not want, which came into the portfolio along with desired alpha sources). CFA Institute Conference Proceedings • 27


Thus, because investors can separate alpha from beta, optimizing alpha sources within each asset class is suboptimal. Instead, investors should optimize the entire portfolio at once and maximize the portfolio’s information ratio, which is alpha per unit of active risk. Let me give an example of why I think this planlevel optimization matters. Suppose you optimize your managers within international, within domestic large cap, within domestic small cap, and so on. That kind of optimization is analogous to eating a meal consisting of the best buttermilk pancakes, the finest sweet and sour chicken, a huge piece of rich chocolate cake, and an ice cold soda. Each one of those foods individually might have been optimal, but when you put them all together, you get a stomachache. The same principle applies to your portfolio. Your best international managers might be highly correlated with your best domestic or small-cap managers. Thus, it is better to optimize at the portfolio level and make sure you have the best information ratio or most consistency at the plan level.

Better Beta Typically, the liability that investors are striving to fund is more bond-like than equity-like. Often, it has a component of both, but generally, the liability is skewed toward bonds. Portfolios, however, are frequently more heavily skewed toward equities. Effectively, investors have taken an implicit bet that equities will perform better than bonds, which will help them fund the liability more cheaply. Now, that might be a fantastic bet. For example, in 2003, it was a fabulous bet. Of course, 2000–2002 illustrates that sometimes it is a poor bet. The point is that the beta exposure should look like the liability unless the investor wants to take an active bet. So, the fourth step involves neutralizing any undesired beta exposure that was created in step three. Once step four is completed, the only beta exposure that remains is either pure liability hedge or beta tilts in the growth portfolio that were purposefully taken to generate return over the liability.

Better Alpha The policy or hedge portfolio accomplishes some wonderful things with regard to risk reduction. But one downside to building a hedge portfolio is the cost. Therefore, building a growth portfolio that can lower the cost of dedicating part of the portfolio to hedging the liability is important. And one way to accomplish that task is by maximizing the information ratio. 28 • CFA Institute Conference Proceedings

Two of Barclays Global Investors’ managing directors, Richard Grinold and Ronald Kahn, wrote a book in which they describe the fundamental law of active management (FLAM).2 The FLAM sees the information ratio, which is a measure of consistency, as a function of three things: • Skill—how well a manager can forecast what he or she intends to forecast. • Breadth—the number of independent bets a manager can place in a year (i.e., the opportunity to apply skill). • Efficiency—the degree to which a manager can efficiently translate insight and skill into portfolio holdings. Skill is fairly straightforward. It is related to the correlation of the forecast with the item being forecasted. Thus, the more skilled I am, the higher the correlation between my forecasts and their outcomes. An easy way to explain breadth is with a Las Vegas analogy. I do not think anyone would be surprised to find out that Las Vegas casinos are an incredibly successful business. But what if Las Vegas operated differently? What if Las Vegas was open only one day a year and shut down for the remainder of the year? Imagine that a casino in Las Vegas under these circumstances retains the same edge but that all the money that was going to be bet over a year is aggregated in one big bet. Las Vegas would quickly cease to exist. Despite having the same edge, too much volatility would be concentrated in one bet. In other words, the casino would have little breadth over which to realize its edge. Of course, that is not how Las Vegas operates. Rather, a casino takes $100 from me, $100 from you, and $100 from the next guy. The casino realizes its edge across an enormous number of bets, giving it tremendous consistency. One of the biggest lessons to take away from the market’s performance over the past three years is the need to do something different. For example, interest in hedge funds exploded because investors began appreciating the need for greater manager flexibility, such as the ability to short securities. The ability to express an opinion on both the upside and the downside gives hedge fund managers that greater degree of flexibility. With greater flexibility and fewer constraints, managers can potentially generate less risk for every unit of alpha. 2 Richard C. Grinold and Ronald N. Kahn, “The Fundamental Law

of Active Management,” in Active Portfolio Management: How to Build Your Portfolio to Maximize Returns and Minimize Risk, 2nd ed. (New York: McGraw-Hill, 1999).



Hurdles to the “Superior” Approach Although this new approach is superior to current methodology in many ways, it is only fair that I point out some of the hurdles that investors will face in executing this approach. Chicken and Egg Problem. To the extent that investors embrace this approach and really go out to seek alpha, they will be first movers. It is to their advantage that a lot of good alpha sources are not yet at capacity. The disadvantage is that not many instruments exist that let investors unwind their beta efficiently. For example, the Lehman Brothers Aggregate Bond Index is not the easiest beta exposure to unwind if an investor finds a core manager that the investor thinks really adds value. Likewise, the MSCI EAFE Index is not the easiest exposure to unwind either. Instruments and techniques are continually being developed; many of them are coming to the mainstream. Such developments will make beta neutralization much easier to process in the coming years. “Surplus Beta” and Alpha Treated Identically. If an investor takes a bet on beta in his or her portfolio, such as a tilt toward equities versus bonds, the investor has to run a horse race between that bet and other alpha sources. The investor cannot assume that equities will beat bonds just because that has been the historical experience in the United States. For example, equities do not look like such a sure thing if one looks at the long-run experience in Germany or Canada. Thus far, U.S. investors have seen only one sample on equities versus bonds. But they need to make sure that they rely on forward-looking forecasts versus historical experience. Not Necessarily Mean–Variance Efficient. The allocation solutions found under this new approach will not necessarily be mean–variance efficient. They are better! They are mean–variance efficient versus the liability. Increased Importance of Finding Good Managers. Probably the hardest part of this approach (and perhaps of any portfolio construction approach) and the biggest hurdle to overcome is finding good managers. Distinguishing the very good managers from the not so good is difficult. The distinction becomes especially important within the context of this new approach because it relies more heavily on alpha sources for return. The positive side is that investors are less dependent on accurate ERP ©2004, CFA Institute • cfa pubs.org

forecasts because beta is likely to play a smaller role in portfolio return. Consistency vs. an Equity Tilt. The question is: Does this new approach provide a higher information ratio (i.e., better consistency) than an equity tilt? As long as one builds a growth portfolio with an expected information ratio or Sharpe ratio in excess of the Sharpe ratio of the ERP (about 0.30), then the new approach should deliver more consistently. One issue is that sooner or later the capacity of reliable alpha sources could be exhausted. At that point, investors have to take the equities-versusbonds bet. But in the meanwhile, I am suggesting that instead of spending 90 percent of a risk budget on the equities-versus-bonds decision and 10 percent on the active management decision, do the reverse. Find the most consistent sources or alpha and work down to the least consistent sources. Allocate capital accordingly along the way. Cost. Implementing this new approach costs more money. But this approach is worth implementing for the same reason that we buy insurance. Insurance has a negative expected return, but we pay for it because we value consistency. Investors do not want to go through that hiccup where something unexpected happens and they have to take a huge hit to their portfolio. To the extent that the new approach will deliver performance more consistently, it is worth paying a higher price.

Conclusion As managers, we should take Peter Bernstein’s advice to heart in that we are not very good at forecasting the long run. Basing the bulk of our portfolios’ performance on long-run forecasts puts us immediately on shaky ground. If we continue to use the current approach to develop our portfolios, at least we should be aware of the implicit bet we are making and appreciate the concurrent risks. Any beta exposure we have and any tilt versus our liability structure is an active bet. It has to be recognized as such and should be compared with the other active bets in the portfolio. The other point to keep in mind is that separating alpha from beta just makes good sense. No reason exists to hold the alpha captive to the beta that it comes with. We can unwind the beta. Beta is cheap and easy to find. Finding good sources of alpha is the hard part. My recommendation is to find the best alpha sources and not worry if they come with a beta attached because most of the beta can be unwound. CFA Institute Conference Proceedings • 29


Question and Answer Session Kevin Kneafsey Question: Given that hedge funds are generally net long beta, is it not inappropriate for them to be advertising Sharpe ratios as opposed to some sort of information ratio? Kneafsey: If all you are buying is a beta tilt, then truly it is better suited to the Sharpe ratio. But I would say that the Sharpe ratio is going to mask the two things that are in that portfolio—the beta and the alpha. Scrape away that beta and see how much alpha is left after you neutralize the beta tilt. Once you get that far, it is easier to compare how much value added you are getting above and beyond what you could simply achieve by levering up a beta bet.

Alternatively, I’m saying that your core portfolio should look like your liabilities. Everything you do on top of that hedge is in pursuit of return above and beyond liabilities. Question: If a professional investor is trying to exploit what you’re suggesting, would there be problems in the implementation by using funds of funds rather than individual alpha-generating strategies because it wouldn’t be as easy to offset or neutralize the beta bet? Kneafsey: It would be more difficult to the extent that you would lose some of the transparency or ability to determine not only the actual exposure but also the beta component of that exposure.

Question: Wouldn’t your approach inevitably lead to more bonds in pension portfolios?

Question: It sounds like a great theory, but how does it work in practice?

Kneafsey: Yes. Because the liability tends to look more bond-like, you put more bonds in the portfolio. Don’t worry about the fact that bond managers don’t tend to generate a lot of alpha. Don’t tie the alpha to the beta. You can accomplish a lot of hedging through futures. For example, you could use T-bond futures to lay out a liability structure or a policy portfolio that looks like your liabilities. Then, you would still have a lot of capital left over to seek out returns above that.

Kneafsey: Let me give some examples. If you manage money for someone else, you probably allocate a lot less capital to your small-cap managers than to your large-cap managers. But aren’t you letting your small-cap managers have more risk per dollar that they are given? You probably do the same thing for international managers. What you have actually done in those instances is ported alpha per dollar of capital. What you are really doing is trying to generate more alpha from the capital you have allocated to your small-cap manager because you want to spread that alpha over the whole portfolio. For large-cap domestic stocks, there isn’t as much opportunity, so you allocate a lot of capital but not a lot of risk per dollar. So, you are already porting alpha without even really thinking about it. Second, I would point out that people are already taking small steps toward the approach I’ve

Question: Is what you’re discussing at all akin to the old approach of core/satellite investing? Kneafsey: With a core/satellite approach, you are trying to generate value and diversify exposure by putting a large amount with lower risk managers and then allocating little bits to high-risk managers. With that approach, each asset bucket tends to look like a separate core/satellite.


outlined. For example, alternative asset classes typically use a cashlike benchmark, such as cash plus some amount or inflation plus some amount. In using them, what you are doing is moving part of your portfolio to something that doesn’t have a huge beta bet component. That is why alternative asset classes became so attractive in the three years that the equity markets were down. Question: If everyone followed your advice, wouldn’t the massive shift of capital create a lot of capacity problems? Kneafsey: Think of it this way: The most efficient areas would become less efficient. Is that a bad thing? Not if you are the first person in, right? If you are in early, then you would get the alpha while it degrades to the point where it is comparable to other sources out there. Doesn’t it make sense that there should be these pockets where alpha is more readily abundant? You should try to be the people who are arbitraging those inconsistencies. Take advantage of it. Yes, you’re going to drive it away, but you will make money on the way. Question: What are the reputational risk aspects for someone who implements what you are saying? Kneafsey: I think career risk is the number one consideration. With the methods I’ve outlined, you will be off the roller coaster. Whether that is good or bad will depend on where the roller coaster is headed. You would have looked like a laggard in the late 1990s but would have come out looking good between 2000 and 2002. Ultimately, your career risk will depend on how much whoever is evaluating you values consistency over the higher possible returns you can get on the roller coaster. ©2004, CFA Institute • cfa pubs.org

Risk Management in a Fund of Funds S. Luke Ellis Managing Director FRM Ltd. London

For the fund-of-funds manager, managing risk in a portfolio of hedge funds requires, first, recognizing that the return distribution of hedge funds is not normal and, second, taking into account the market crisis events that should happen rarely but that, in fact, occur every two to three years. Fortunately, value at risk methodology can be adapted for measuring the normal risk in the fund portfolio and, with some modification, can be applied to estimate how much the portfolio might lose in a crisis. In addition, modeling crises as coherent events allows one to estimate the likely amount of loss requiring a hedge, even though the particular nature of a future crisis may be unknown.

he most important point about managing risk in a fund of funds is to recognize that it is completely different from managing risk in an underlying portfolio. The manager of an individual portfolio can easily adjust risk. A fund-of-funds manager, however, allocates money out to other managers. Although a fund-of-funds manager can manage risk at the overall portfolio level, the fundamental piece of risk management that occurs at the security level is outside the direct control of a fund-of-funds manager because it is, in essence, outsourced. Consequently, a huge part of risk management for the fund-of-funds manager is about picking who gets the money. Thus, managing risk at the security level is about monitoring. Given the limitations on security-level risk management that a fund-of-funds manager faces, overall high-level risk management becomes that much more important. Risk management in a world of funds of funds involves two areas. First, the fund-offunds manager does not want funds that blow up. Of course, the manager wants funds that provide alpha, but in terms of risk management, the best way to control risk is to avoid funds that will blow up. This aspect is where business and operational reviews are important. Second, the manager must understand the risks within a fund-of-funds portfolio and define a solid overall risk management process. The focus of my discussion will center on how to manage risk on disaster days. On normal days, when life is good and things are going as they have for the past 12 or 18 months, risk management is more about

T


simply sitting in the corner and patting oneself on the back. Real risk management comes into play every three or four years—or, in my experience, slightly more often—when crisis events occur in the markets. Those times are when risk managers earn their living.

Defining Risk All fund-of-funds managers think they can pick funds. In my view, the real challenge is the ongoing management of that fund-of-funds portfolio. The fund-of-funds manager must define objectives and, as part of that process, determine appropriate risk parameters—volatility, beta, and tail risk. The definition of risk most people examine first is volatility. It is the easiest risk to control, and it is the least interesting because volatility tells what happens in 29 out of 30 months. It does not deal with what happens in that 30th month when a market crisis occurs. For a fund-of-funds manager, that 30th month is what really hurts. It is the reason why the manager is pulled up in front of a trustee committee and berated. For individual investors, it is that 30th month that means they suddenly cannot spend as much as they thought they could. Thus, the 30th month is important. The second piece of risk is beta in relation to a market. Portfolio beta is relatively easy to control in normal market environments—specifically, by inclusion or exclusion. For example, if the manager



wants portfolio risk to lie heavily in U.S. stock market beta risk, he or she includes a lot of long-biased equity managers. Tail risk, however, is the most important risk to control because it hurts the most. Moreover, it tends to scare managers out of their positions at absolutely the wrong times. The most important lesson about running portfolios is never to run a set of risks in which the risk event will drive decisions. Managers need to determine the worst-case scenario they can accept without panicking and set the tail-risk limit at that point. This step is critical because managers who panic tend to lose the opportunity to shape what happens within the portfolio after the market crisis.

Managing Tail Risk The first and most basic approach to managing tail risk is to recognize when tail events occur, where they come from, and what they look like. The investor or fund-of-funds manager picking other managers must realistically estimate the potential crisis event losses that could occur among the various managers. Investors tend to be nervous about asking managers questions such as: “What happens in the next credit crisis?” or “What happens if there is a 20 percent collapse in the equity market tomorrow?” And managers tend to dismiss those questions as dumb and often reply with: “Don’t be silly. We won’t lose any money in that!” Investors should not accept that sort of answer from their managers. In reality, another 20 percent equity market collapse will occur somewhere around the corner. Likewise, another credit crisis will occur at some point. Some managers will always say: “Well, I am simply going to get out of the way of that bus.” But people usually do not manage to get out of the way of the bus. The bus turns out to be bigger than they thought, and they actually lose more than they thought possible. One approach an investor can use to assess an individual manager’s risk is to ask about the likely drawdown that would be experienced in a market crisis event. Then, the investor can compare that estimate with the fund-of-funds manager’s estimates. Tail risk is generally more significant than most individual managers think. That is, most individual portfolio managers will lose more in a crisis than they believe. But a fund-of-funds manager will tend to spend more time focusing on the probable crisis event outcomes and the implications for all funds in the fund-of-funds portfolio. The complicated bit of this basic approach is that what is right today was not right 6 months ago, was completely different 18 months ago, and will be wrong 6 months from now. The reason for this variability is that the impacts of tail events in a market are different 32 • CFA Institute Conference Proceedings

as the market develops. Additionally, risk managers are making changes over time. Even if the set of managers is relatively static, changes in the environment will shift the risks. For example, convertible bond funds that were very credit oriented 12 months ago were probably equity and volatility oriented two years ago. Today, many are likely oriented toward equity and volatility again. The outcome of a crisis event varies with those changes in emphasis. Consequently, the basic approach must be revisited often. Of course, simply assessing the tail risk that exists is of little help. The important next step for the fund-of-funds manager is to find funds that offset existing tail risk. Fund-of-funds managers must find individual funds that will make money in the tail-risk environment and thus neutralize the existing tail risk. Fundamentally, the hedge fund business has an inherent problem of downside tail risk. Although some types of funds are counter to this problem, most funds have tail risk similar to that depicted in Figure 1 for a typical arbitrage fund. Because of the way fund managers are paid, because of human nature, and because of the nature of markets, fund managers tend to focus on that big hump in the distribution. They focus on making sure they make that 1 percent or 1.5 percent or whatever they are targeting as often as possible. To do that, however, they almost all give up some little bump on the downside. That little bump looks unimportant because it does not occur often. But when it does happen, it hurts a lot. That little bump is the one to worry about. Qualitative Approach: Structural Risk Sectors. From a qualitative point of view, one approach to understanding fund-of-funds risk is to segregate the manager styles in the fund-of-funds portfolio into sectors of structural risk. Exhibit 1 shows four sectors. How much beta-dependent risk, for example, the fund-of-funds manager wants and does not want in the portfolio will drive how much is put in the bottom right-hand sector. Most fund-offunds managers spend their lives in that box or the upper left-hand box, the “structural alpha” box. In the “beta dominated” box are most of the equity long–short funds and a number of other strategies. The structural alpha box contains the classic hedge funds that make money out of some structural inefficiency in the world. Those funds are good things to have in the portfolio because they have the wind at their back and make money over time. But all the funds in the structural alpha box have a return–risk profile similar to the one shown in Figure 1. Their return–risk profile looks that way because to capitalize on structural inefficiencies, they typically end up owning the less-liquid/more-complex assets and are ©2004, CFA Institute • cfa pubs.org

Risk Management in a Fund of Funds

Figure 1.

Typical Arbitrage Fund Return vs. S&P 500 Index Return Frequency (%) 40 35 30 25 20 15 10 5 0 −11

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Exhibit 1.

Sectors of Structural Risks

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No-bias equity: U.S./Europe/Japan Merger arbitrage Fixed-income arbitrage Convertible bond arbitrage Statistical arbitrage Distressed securities Long–short credit (no bias)

Discretionary trading Systematic (nontrend) Tactical allocation

Hedges Short bias Systematic (trend) Long optionality

Beta Dominated Emerging markets Directional exposure Long equity plays Long credit plays

short the more-liquid/less-complex assets. In other words, they own risky assets and are short the less risky assets. In a crisis event, all risky assets go bad together as the price for risk jumps. So, although in a normal market environment the assets in the structural alpha box are all nicely uncorrelated with other assets and appear to be uncorrelated with each other, in a crisis, they are suddenly all correlated. Therefore, the fund-of-funds manager needs some other type of style that will make money in that crisis—that is, a hedge. Cutting off that tail risk is what a hedge is all about. Hedging can come from various parts of the market, but basically, the goal is to estab©2004, CFA Institute • cfa pubs.org

Arbitrage Fund Return

lish a way of buying back an out-of-the-money put on some factor in the market. The aim is something with lots of optionality so that 90 percent of the portfolio can be in the structural alpha part and 5–10 percent in the hedges part. The hedge will be designed to make enough in a crisis to offset the other risk. Sizing the positions to neutralize tail-event losses through a purely qualitative method is difficult. So, the manager needs to find a slightly better way to consider the choices. Improving Hedging: Quantitative Approach. The great advantage of a quantitative approach is that it is objective. A manager may decide it is wrong for various reasons, but at least it provides a starting point for asking difficult questions. The beginning of quantitative analysis in the hedge fund and fund-of-funds business is to recognize that returns are not normally distributed. Consequently, the familiar mean–variance optimization approach does not work well. Some people believe that a value-at-risk (VAR) approach will also not work well as a measure of risk in this environment. But a VAR approach can be very helpful if it is properly adapted. ■ VAR-based approach. VAR is a measure of the potential change in the value of a portfolio of instruments with a given probability over a preset period. CFA Institute Conference Proceedings • 33


The definition of VAR and the application of VAR analysis do not require the assumption of normally distributed returns (although for various reasons, that is a common model). They depend on picking some group of returns that the manager is trying to exclude in the tail. Figure 2 illustrates the VAR concept. For normal distributions, the VAR calculation requires three sets of estimates: expected fund returns, standard deviations of fund returns, and the portfolio correlation matrix. The primary problem with the traditional VAR approach for a portfolio of any size is the number of estimates that are required and the lack of relevant data on which to base them. Two years of data may provide a decent-sized sample set, but any statistician will say that two years of monthly data is not valid for any type of distribution analysis—certainly not for looking at tail events. Furthermore, because things change, exponential decay factors are often applied to data, thereby diminishing the influence of potentially valuable observations that may be too “old.” In addition, the track records of many hedge funds are simply too short to include instances of the relatively rare tail events that may constitute the main risks of the fund. Another big problem with a traditional VAR approach is that risk varies significantly over time; thus, the correlation matrix is not static. A lot of the risk exposure growth occurs at the very time the historical risk measure seems to be diminishing. In other words, the big lesson of 1998 is that if one uses volatility measures that are dampened by a long

Figure 2.

historical period, risk will appear low just prior to the storm, which will encourage the hedge fund manager to hold bigger positions than he or she should. ■ Theta distribution. An approach we have taken at FRM is to model fat-tailed return series by means of what we call a theta distribution.1 Figure 3 shows an actual distribution set of returns for a fund of funds; the dark solid line marks the fat-tailed theta curve drawn to the distribution, and the dotted line delineates a normal curve. The interesting point about these curves is that many people look at such a chart and say that the dotted line fits more of the points of the distribution of actual outcomes than the solid line. A normal distribution applied to a single manager or a fund of funds does seem to fit a great many events, but it does not fit the ones in which the fund loses money. Risk management is all about the events that cause losses, so the normal distribution is insufficient for this purpose. The theta distribution is an extension of the normal distribution in which the exponent gradually passes from x2 in the middle of the distribution to x in the tails. As Figure 4 shows, the tails can be made fatter or thinner by changing the inputs to the model, essentially by interpolating between a normal distri2 bution (the hump marked e – ( x )) in the center and the x -x exponential curves e and e in the tails. 1

The theta distribution is a generalization of the normal distribution developed at FRM. Its form allows the user to specify the degree to which a distribution exhibits fat tails.

VAR Illustration Frequency 0.5

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Figure 3. Fat Tails and Coherent Events: Normal vs. Theta Curves for Fund-of-Funds Return Distribution Frequency

Normal Curve

Theta Curve Return

The theta distribution is a flexible tool that can match an individual fund or strategy in a portfolio. Different strategies, depending on their risk levels, correspond to different parameter values in the model. The result is a mathematically defined picture that provides a much better representation of observed tail returns than a normal distribution. The theta distribution is a useful model for returns in normal market conditions, but it does not quite get

Figure 4.

to the heart of the fund-of-funds manager’s biggest worry—what happens when a market crisis occurs. The Crisis Market. A market crisis happens regularly and more often than managers like to believe. Consider the following: • February 1994—unexpected Fed rate increase, • October 1997—DJIA closed limit down with a one-day loss of 554 points (7.2 percent),

Theta Distribution

Frequency 1.2

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August 1998—Russian default and equity market crash, • October 1998—plummet of Long-Term Capital Management, • Fourth quarter 1999—liquidity flood, • Second quarter 2000—NASDAQ bubble burst, • September 11, 2001, and • May/June 2002—WorldCom. This list contains a market crisis at the rate of about one every other year, and each crisis is unique; thus, the impact is unique. In almost every case, the crisis is on the downside. The only upside crisis of note is the one in the fourth quarter of 1999 when the market was completely driven by the Fed-induced liquidity ahead of Y2K. A crisis market is like the proverbial 100-year storm: It is predicted to come only once in 100 years, but when it will come cannot be predicted. It is often said that in a market crisis, all correlations “go to 1.” That statement certainly captures the idea that everything goes wrong at once, irrespective of normal correlations, but it does not actually provide a good basis for modeling crises. It is true that analysts cannot predict when these critical events will occur, but I am advocating that analysts work to understand them because analysis can be used to predict potential outcomes, which is the first step toward doing something to counteract them. Rather than trying to predict the correct correlation matrix, managers can look at the storm that occurs once every 100 years as a coherent event in which risk cannot be diversified away by normal means. For example, in the midst of the Russian default and equity market crash in August 1998, fundof-funds managers suddenly found that the standard diversification they had built into their portfolios did not work. All the basic hedge fund strategies—those funds in the structural alpha and the beta dominated boxes of Exhibit 1—lost money together. How can fund-of-funds managers accurately incorporate the possibility of crisis events into a portfolio concept? The challenge goes beyond modeling fat tails; the coherent event itself must be modeled. The first step is to establish a model in which a set of hedge fund distributions can be represented by a bimodal distribution, as depicted in Figure 1. The bimodal distribution incorporates both a normal environment (the main mode) and a crisis environment (the tail mode). The fund-of-funds manager picks a great number of hedge funds and uses an optimizer to diversify risk. In a normal environment, risk should diversify away through imperfect correlation, even if correlations among managers are not that low. Of course, managers must also then concern 36 • CFA Institute Conference Proceedings

themselves with the crisis event because if it occurs, correlations will dramatically increase and most hedge fund strategies will hit the left tail of the bimodal distribution at about the same time. If the manager could model the situation by means of a different set of correlation matrixes, that would be great. The trouble is that the manager would be guessing the answer to the following question: What happens if the correlations go to +1 and –1 in that environment? In much analysis done by fund-offunds managers, they say something like: “If you look at August 1998, the correlation between the equity market and the returns of commodity trading advisors was –1; therefore, I am going to use –1 as my predicted correlation number in the next crisis.” The trouble is that the relationship that drove that correlation in 1998 is different from the one that exists today and from the one that will exist in the next crisis event. Commodity trading advisors made a load of money in August 1998, but it was not because they were all somehow short the equity market at that time. Rather, almost all of them made their money out of the bond market. They were very long bonds, and that crisis month experienced an extremely strong negative correlation between bonds and equities: Bonds rallied out of sight as the equity market collapsed. Today, bonds are at a very different level in commodity trading advisor portfolios from what they were four years ago. The risks they are taking in the bond market are different. So, what correlation should the fund-of-funds manager expect for the next event? What we do at FRM is leave the correlation matrix unchanged but build in a new factor that describes the degree of return coherence brought about by a market event. The model structure is the same for all the funds. That is, return to each fund (and each strategy) is modeled as a bimodal distribution with a (typically fairly low) probability that a return will be drawn from the left tail (the negative hump, as in Figure 1). The degree of coherence corresponds to the strength of the tendency for returns drawn from their respective left tails to occur at the same time for different funds. We ask: How coherent do we think those events are going to be in the future, and therefore, what is the nature and amount of the offset that we need? In summary, we break risk assessment and management into two parts: • the risk associated with fat-tailed distributions, which we take to be representative of risk levels in the absence of a market crisis and which, broadly speaking, can be managed through normal diversification, and ©2004, CFA Institute • cfa pubs.org


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the much higher level of risk that accompanies large-scale market events, which must be hedged explicitly.

Future Risks In terms of learning the lessons of the past, market participants have learned the lesson taught by 1998 and maybe the lesson of 2002, but the lesson of 1994 seems to have been forgotten. The coherence of a Fed rate hike, however, is at least as strong today as it was in 1994. Too many managers in the hedge fund industry today are trying to make a carry trade based on their belief that the Fed is going to wait longer before raising rates. The carry is tiny. The only way a fund can make a carry out of such a short-gamma strategy on the front end of the U.S. curve is to have a lot of it. It must be levered up many times. This strategy is not always clear to a fund-of-funds manager from the leverage numbers provided by the fund managers because they provide a 10-year-equivalent number. In terms of the gross balance sheet, however, hedge funds and investment banks are taking an enormous amount of risk on that front end of the yield curve. Maybe the Fed will not do anything soon, but if it does, a lot of funds will be affected. Some analysts have argued that a rate hike will affect the macro funds but nobody else. I think that is unlikely. Consider the math: If a carry arbitrage trade is yielding a 6–7 percent unleveraged spread or high-yield bonds are yielding more than 6 percent on an unleveraged spread, hedge funds are all over it. They like it because it looks like gross (unleveraged) 5–6 percent over LIBOR. And with a bit of leverage, the fund can take its fees and still show investors a nice return. But suppose it is an arbitrage spread—that is, this security


has a yield to the arbitrage constraint of 6 percent. If rates go from 1.5 percent to 4 percent, suddenly the spread on that trade needs to go from 6 percent to 10 percent simply to maintain the same spread to LIBOR. Some other analysts believe that the Fed will raise rates gradually over time, so the spread will take a while to widen. In reality, however, the market is priced on expected spreads, not current spreads. Thus, if the environment shifts over four to six months from a perennial 1 percent rate environment to a 4 percent rate environment, funds have to rapidly discount those spreads. Instead of 6–7 percent gross to meet return projections, the funds need 10–12 percent gross. Only the first couple of hedge funds need to start adjusting before a dramatic move begins because the spread was levered three or four times and nobody wants to be the one who loses 4 percent levered three or four times. So, today’s concentrated bets have been made on two coherent factors—credit spreads and no Fed rate hike. Does the process of mapping the coherent risk plus the fat-tail distribution work? In the last three coherent events, FRM delivered outcomes in real portfolios that reflected no significant impact from the following crises: • 2000—peak-to-trough loss of 0.46 percent, • September 2001—positive performance, and • 2002—peak-to-trough loss of 1.1 percent. But as the baseball saying goes, we are only as good as our next turn at bat. When the Fed raises rates, the market impact will be big. We think we have built the fund-of-funds portfolio to withstand it, but it requires a lot of active management of the hedging to maintain the balance.



Question and Answer Session S. Luke Ellis Question: How can someone assess tail risk for unprecedented events? Ellis: The next crisis will not look like the last crisis, but it might look like the one 10 years ago. The fact that it doesn’t look exactly like the last one does not mean you cannot assess the risk in a portfolio. The point is not to hedge to the nearest basis point. It is broad-brush hedging. So, if you avoid getting caught in the minutiae and instead look at the big picture, you can see a pattern to all the crises. If the fund managers in your portfolio and across the market have similar risks, you can gain a sense of the magnitude of the outcome of the next crisis for them. No one can tell you the exact outcome of the next crisis or when it will occur. But it is possible today to estimate the impact on a fundof-funds portfolio within 25–50 bps. Then, it is possible to establish the opportunity for the hedges. Turning a potential tail risk in a fund-of-funds portfolio from 5–7 percent into 50–100 bps is a worthwhile exercise in hedging. Question: Can you differentiate credit risk from equity risk even though they are so closely correlated? Ellis: Differentiating credit risk from equity risk is certainly a worthwhile exercise because it helps you find the cheapest available hedge. The prices of hedges in different parts of the market are not the same. A credit crisis will probably create some issues for equity—but only probably because, on the basis of relative valuation, credit could sell off a long way before it becomes cheap relative to equity. An equity crisis

will definitely have an impact on credit. So, differentiation encourages you to look at pricing for the hedges in those two markets. Question: Why is the dispersion in returns in the fund-of-funds universe so thin? Ellis: It depends on what happens at different times. First, returns are not necessarily highly correlated in certain market environments, and you must decide your tolerance for risk in those environments to decide which distributions you are most comfortable with. Second, when you build a portfolio of 20, 30, or 50 hedge funds, much of the noise is diversified away. The effect is to create statistically similar looking payoffs because the skill, the added value, and the risk management are in the elements around the edges. Whether you were up 1 percent in January is not important because everybody—the whole hedge fund business—had a good January. Maybe August will be bad, but it is the variations within those months that tell you where the skill is found. Question: What alternative risk measures, such as downside deviation and kurtosis, should be considered? Ellis: A number of measures are useful. The important point is that standard distributions do not work, so you need some measure that takes account of the downside incremental tail risk that you are taking with a hedge fund. You need to be careful about relying on any one number. I learned from managing traders over the years that if you give them a number and tell them it is what you are looking at as a measure, they will optimize to look good on


that number. But by optimizing that way, they will be throwing something else away. And often, the baby goes out with the bathwater. So, if you are looking only at Sortino ratios because they are a bit more informative than a Sharpe ratio, or downside deviations versus standard deviation, or drawdowns compared with average returns, or so on, you will end up seeing the trees and not the forest. The natural inclination of any investor looking at historical results is to invest in the one that has made a lot of money in the past. Human nature is not to buy the thing that did badly yesterday simply because you think it might do well tomorrow. Human nature is to buy the thing that did well the last five days. So, you need to build into your process things that will stop you from following that pattern. At FRM, we have found that most sets of historical numbers for hedge funds cannot be distinguished from randomly generated sets of numbers. If you take the 200 or so convertible hedge funds out there, for example, statistics will tell you that, just randomly, 10 will have made money every month for the last five years. That statistic does not mean that those 10 are great but that statistically, with 200 managers and with a certain volatility, 10 will make money. So, we constantly try to stop the analyst from becoming enamored with historical results. I refuse to look at numbers before I meet with a manager. I look at them when I come out of the meeting. It is an interesting discipline. If I look before, I am tempted to be nice to the fund manager if the numbers are good. Afterward, I look at those numbers and see if I ©2004, CFA Institute • cfa pubs.org

Q&A: Ellis

can reconcile them with the manager’s stated strategy. The investment decision that I feel most comfortable with is the one we made in 2003 to sell a fixed-income manager with a Sharpe ratio of six. We sold that manager because we could not reconcile fixed-income arbitrage with that high a Sharpe ratio. You do not find that sort of Sharpe ratio out of an asset strategy that everybody in the world knows about. In fixed-income arbitrage investing, many people are playing the game, and a great deal of bank capital would be delighted with a Sharpe ratio of one. In truth, the world has too many animals snuffing out truffles to give anybody a Sharpe ratio of six. So, from the standpoint of any measure, you need to ask not simply is the outcome good on this measure but is it also credible. Question: What is the one question that should be asked of


fund-of-funds managers that is not asked? Ellis: First, I’ll give you the flip side of that question, which is what clients ask us most about. They ask us where we think we add the most value—manager selection, portfolio construction, or risk management. They get the most unhelpful answers because without a decent benchmark, no one can answer that question. We do lots of analysis because people ask us for lots of analysis and they go away feeling comforted by those data, but that analysis provides little insight. Starting in about 1999, we have seen an amazing change in the due diligence that potential clients do on us. Five years ago, people would come in and ask what we did before we did this job. Then, they would look at our track record and give us a check or they would walk out. But recently, we had a five-hour due diligence session

with a potential client, and it was this client’s fourth round of coming in. That approach is good. Investors today are taking the time to ask many difficult questions, but I think they should ask more questions about how we manage our capacity pipeline. Capacity is crucial in this business. Do not ask: “Can you get me capacity?” Everybody will say they can. Instead, ask how they plan out future capacity, how they adjust client inflows and marketing to reflect that plan, and how they deal with variability of capacity. Good capacity is episodic. One month, no hedge fund seems to want fund-offunds money. The next month, they are all banging on the door asking for $100 million. A fund of funds has to manage that problem, and it is an entertainingly complex problem to manage.


Monitoring Fund-of-Funds Allocations Alain De Coster Principal ABS Investment Management, LLC Greenwich, Connecticut

Hedge funds do not lend themselves to the same approaches used for monitoring traditional investments. To analyze hedge funds well, a very flexible and hands-on approach must be used. Although hedge fund investors generally do a good job of reviewing hedge fund people, strategies, and implementation, they often overlook equally important elements, such as redemption characteristics, investor profiles, equity ownership, and motivation policies. A three-pillar approach that looks at the business, the investment, and the operations can help investors adequately analyze and, most important, continuously monitor their hedge fund investments.

n this presentation, I will describe a philosophy and methodology that are helpful for monitoring hedge fund investments. Part of the challenge is that the very nature of hedge fund investments and the many differences between traditional investments and hedge funds result in a situation where hedge funds do not lend themselves to the same approaches used for monitoring traditional investments. In Exhibit 1, many of the bigger differences are outlined. Foremost among the differences is that traditional investments have more standardized strategies than hedge funds. Hedge funds, even those that pursue the same basic strategy, may use very different ways to extract return. Consequently, one needs to have a hands-on and flexible approach to analyze hedge funds. In addition, traditional investments are more heavily regulated. It appears that hedge fund regulation will increase, but I suspect hedge funds will always be less regulated than investors would like because of the nature of the investment. Benchmarks are a rather obvious difference. For example, analyzing traditional investments is easier than analyzing hedge funds because traditional investments have clear benchmarks and investment guidelines. Related to that issue is the fact that differentiating alpha from beta is easier for traditional

I

Editor’s Note: The joint Question and Answer Session of Alain De Coster and Robert Swan follows Robert Swan’s presentation.


investments than hedge funds because hedge funds have a more convoluted mix of alpha and beta. Transparency is typically good for traditional investments. For hedge funds, however, a tug of war has been taking place about how much transparency is necessary. Some managers provide fantastic transparency, and others provide none at all. As an investor, you may choose to invest only with people providing adequate transparency. Unfortunately, you will be limiting your opportunity set quite a bit and will miss a lot of great investments. Other differences that investors should keep in mind include capacity, people, and liquidity. Capacity is plainly limited among hedge funds. Likewise, good talent is unfortunately limited. Individual managers are the key to success for many hedge funds, so spending a lot of time and effort in getting to know the manager is critical. Evaluating the manager becomes especially important in cases where liquidity is limited. With top-tier hedge funds demanding lockups of several years, the investment becomes quasi private equity. All these differences between traditional investments and hedge funds point out the need for a very flexible process for evaluating hedge funds. The nature of hedge funds requires a due diligence process that is more qualitative than quantitative and that focuses on quality of information over quantity. Moreover, the hedge fund industry is a fast-changing animal and thus requires constant monitoring. In essence, the evaluation process must be ongoing.


Monitoring Fund-of-Funds Allocations

Exhibit 1.

Differences between Traditional Investments and Hedge Funds

Traditional Investments

Hedge Funds

Standardized strategies

Highly differentiated strategies

Highly regulated industry

Structural risks

Benchmarks

Absolute returns

More beta than alpha

Various mix of beta and alpha

Transparency

Tug of war

Large capacity

Limited capacity

Process and institutions

People

High liquidity

Low liquidity

Source: Based on data from ABS Investment Management.

Balance Sheet Analogy In conducting due diligence, investors commonly look at the relevant people, their bios, their profiles, and the way they are organized. Investors also strive to understand the strategy and determine if it is likely to work well in the future. Furthermore, they focus on the way risk is managed and the way the fund is operated. These are the issues where investors spend most of their time, and they are all important issues. But if one thinks of a balance sheet analogy, such as the one depicted in Exhibit 2, investors tend to focus on the asset side of the balance sheet at the expense of liabilities and equity. Liabilities include the current investors and types of investors in the fund. Additionally, liabilities include such things as the hedge fund’s redemption characteristics in relation to the liquidity of the underlying securities/portfolio. Equity in this analogy refers to who is running the hedge fund, what the manager has at stake, and what policies are in place to motivate successful behavior. Any change to one of these three areas (assets, liabilities, and equity) could mean that the “balance sheet” has changed; thus, changes should result in complete reconsideration of the investment as if it were a new investment. Exhibit 2.

Hedge Fund Balance Sheet Analogy

Assets People Team profile Organizational structure

Liabilities Redemption characteristics Investor profile (institutions, high net worth, etc.)

Strategies Soundness of strategy Focus Implementation

Equity Equity ownership Motivation policies

Operational issues Risk control Source: Based on data from ABS Investment Management.


Monitoring At ABS Investment Management, we use a threepillar system, first, to help determine what gives a fund its competitive edge and, second, to ensure that this competitive edge stays in place. The three pillars are business, investment, and operations. We try to monitor each aspect independently and then put them together as a cohesive view of the fund. Business Monitoring. Business monitoring has two major aspects. The first is to evaluate the organization itself. The second is to understand the fund. ■ Organization. We think the obvious place to start in evaluating the hedge fund as a business is to look at the organization itself, which includes evaluating the team and the organizational structure. We begin with a look at the team’s experience in money management. Ten years ago, few people had solid hedge fund experience. Now, things are very different, and we more frequently see managers starting their own shops and bringing true hedge fund management experience to the table. Other important factors to evaluate when looking at the team’s profile include ethics and reputation. I have found that a manager’s reputation among his or her peers is very telling of quality. It is evident that a hedge fund needs a good investment manager. Equally important, however, is that the manager be good at the operation side, which requires a business sense. At the least, the manager should understand the business well but delegate the operation function to a talented business manager. We evaluate this issue by examining the organizational structure, and we have found that the quality of infrastructure is very important, as is whether the manager is reinvesting in his or her business. Additionally, it is important that the manager have a business plan that is applied consistently over time. We also look at the team around the manager. We would rather see a team that has experience working together than a group of people coming together from different horizons just to seize an opportunity. And even when a good team is in place, we investigate the motivational policies for keeping people and preventing turnover. Finally, we make sure to understand the equity. That is, we want to know who owns the equity and what is the stream of fee income. We have found that seeing how much is at stake for the equity owners and making sure the structure encourages long-term business success are important. ■ Fund. On the fund side of the analysis, understanding the investor profile is important. This step involves looking at such features as the marketing approach used to raise money and the client services CFA Institute Conference Proceedings • 41


approach. Also important is knowing the others who are invested and discerning whether their reasons for being in the fund are similar to ours. Finally, we want to know if everyone invested in the fund gets the same treatment in terms of fees and liquidity. Liquidity, of course, is of extreme importance and deserving of its own scrutiny. If nothing else, an investor should know if the manager has another large account buying the same securities. But the investor needs to go beyond that and drill down to the underlying securities and the liquidity of those items. Understanding this information from the start and then checking it during the life of the investment are important because liquidity changes as a fund grows. Investment Monitoring. The second pillar in our process involves regularly capturing and analyzing investment-related information for the fund. An important aspect is maintaining an ongoing, accurate picture of how the manager is running the portfolio, which entails monitoring all the exposures within the fund—currencies, delta, beta, cash, market capitalization, country, industry/sector, and so forth. Understanding where the manager is concentrating his or her bets is critical. Equally important is making sure that this information is in line with the manager’s stated strategy. Moreover, investors should analyze the manager’s performance relative to the market environment and compared with his or her peers. This last step is the qualitative part of the process and is where investors need to develop a benchmark for determining if performance is attributable to the manager or to the strategy as a whole. Operational Monitoring. Operational monitoring starts with an assessment of the adequacy of back-office personnel. In evaluating the back office, do not overlook service providers. The use of service providers in the hedge fund industry has exploded. Some of those providers are totally understaffed, so the quality is all over the map.


Another aspect of operational monitoring is to understand the quality of the operational and accounting structure. Ultimately, investors should ensure that the fund is operating in accordance with the offering documents. Although the fund should obviously be doing so, this is not always the case. This area is one where investors need to delve into compliance, control of trading, pricing policy, and soft-dollar policy. Additionally, investors must examine the roles of the fund administrator and the auditor. For example, it is a bad sign if the auditor is used only as a step of approval but no underlying relationship exists. By nature, the due diligence process for operational monitoring is very hands on. We have found the best way to accomplish good operational monitoring is for our chief financial officer (CFO) to visit and build a relationship with the hedge fund’s CFO, chief operating officer, and/or CEO. Over time, we have discovered a few warning signs to watch for on the operational side. Foremost, employees on the operational side of hedge funds should not be treated as second-rate citizens within the hedge fund firm. Ultimately, they are the key to the success or failure of the hedge fund. Furthermore, investors need to keep an eye on the financial statements. I am often surprised by how many investors do not review the audited financial statements. In addition to reviewing the statements themselves, investors should check for timeliness of investor reporting because delays can be a sign of problems.

Conclusion Good hedge fund investing involves a solid teamoriented approach. To do the job right takes a lot of time and effort as well as having the benefit of multiple perspectives. In our firm, we want every investment professional to share the responsibility for monitoring our hedge fund allocations. The real value that a fund-of-funds manager adds, or that an investor can add for himself or herself, stems from a focus on quality of information and a balanced view.



Question and Answer Session Alain De Coster Robert P. Swan III Question: How do you feel about negotiating with hedge funds on fees? Are you believers in side agreements? Swan: It is a benefit to our clients to negotiate fees when we can. One of the reasons clients come to us is that we have generated the leverage in relationships over time and arrived at a position where we are often able to negotiate fees. The key is not to drive down fees to the point where we are not a partner with the manager. Rather, we strive to get to a point where we are in agreement as to what we are doing for each other. Some very successful firms will not negotiate fees. In those instances, a fund-of-funds manager just hopes to get capacity. So, without question, we take the opportunity when it arises to negotiate reduced-fee relationships because that directly benefits our clients. Question: Do you see capacity as a problem? De Coster: Capacity is definitely an issue. First, the number of analysts and the quality of their research are limited and can only be increased over time, so having managers with a clear understanding of what they can do with the current staff is important. Second, market liquidity comes and goes. And flexibility and liquidity tend to disappear at the precise time that managers need them most. The issue is further complicated by the fact that it is difficult to gauge exactly where capacity should be set. Managers obviously want to be prudent so that they will be in business five years from now. That said, there are always new people opening their

doors with new strategies and new opportunities. Swan: Capacity often follows the 80/20 rule. That is, the best managers are in the top 20th percentile, and that is obviously where you hope to find opportunities. Capacity also tends to follow a moving scale in that it cycles up and down based on changes in the equity, credit, and fixed-income markets. Fortunately, we are presently pretty excited about the opportunities we are seeing in the current hedge fund cycle. Question: Does it worry you when you hear about soft closes versus hard closes? Swan: I think closes are an important thing to monitor with hedge fund allocations. It is a problem when managers do not understand their capacity constraints and how they affect their ability to continue extracting an edge with their strategy or investment philosophy. When I meet with managers, it is a high priority to get an understanding of whether capacity will dictate a soft close or a hard close. If the manager claims he or she will hard close at a certain point and the fund later blows through that level, I want to know about it immediately and find out why the manager is still raising assets and whether it is supported by the opportunity set presented to the manager. Question:

How about liquidity?

De Coster: It is paramount that fund-of-funds managers ensure there is not a breakdown between the liquidity provided to their investors and the liquidity provided by the underlying funds they invest in. Some fund-of-funds


managers offer more liquidity to their investors than we do, but they are running a liquidity risk that can ultimately hurt their clients. We do not take that risk. Similarly, it is important to understand the liquidity of the underlying investments within the hedge funds in our fund-of-funds portfolios. The liquidity of those underlying investments should be in line with the liquidity that the hedge fund manager offers. Swan: Liquidity is certainly a key issue in hedge fund investing. We do our best to understand liquidity constraints and strive for a balance that makes sense. For example, if someone is operating in a distressed category and is offering monthly liquidity, that is a mismatch. We strive to understand the underlying asset class and combine those risks accordingly with the liquidity we offer our clients. Also keep in mind that liquidity varies in different stages of a hedge fund’s business. When a manager is growing dramatically and has consistent inflows, the liquidity picture is a lot different from when money stops coming in or when the manager stops taking assets. We make sure that we understand where a hedge fund investment is along that life cycle and the subsequent impact on liquidity. Question: Is there a correlation between funds willing to provide transparency and subpar performance? De Coster: I think the first thing you have to do is define adequate transparency. For us, transparency is not about knowing every single position held by every manager in our portfolio. Full transparency is ©2004, CFA Institute • cfa pubs.org

Q&A: De Coster and Swan

not the best use of time both for the manager and for us. Of course, we still do site visits to discuss large positions and concentrations in the portfolio. But we believe the key issue is to understand the portfolio structure, the risks, and how the portfolio changes over time.

Question: How do you assess offshore administrators?

Question: How often do you require net asset values (NAVs) from your managers?

Swan: The offshore administrators have been slowly consolidating onshore. So, we simply conduct the same analysis. We make sure that we understand the infrastructure. You have to do good work on both the manager and the administrator. You cannot count on administrators and auditors to find problems because they will ultimately point their fingers at the expert manager who is providing valuations.

Swan: Generally, it is difficult to get a full accounting close from hedge funds more frequently than once a month. At a minimum, we require monthly NAVs with independent documentation to support their valuations. We are fortunate to have good reporting relationships even with the fund managers that typically provide only quarterly reporting. Question: Do you have requirements for minimum track records or assets under management? De Coster: If you find a good manager but wait for a three-year track record, you are likely to discover that the manager is closed by the time you are ready to invest. Consequently, due diligence around issues other than the track record and assets under management becomes important so you can accurately gauge the quality, the valuation, and the future prospects. Swan: At one time, a three-year track record was our minimum requirement. But growth of the industry and competition for solid opportunities have pushed that requirement back. Consequently, vetting out other aspects of the manager’s history, such as background and reference checks, is all the more important. So, to answer the question, we look for a track record but are willing to accept situations where other substantive due diligence work indicates a solid opportunity. ©2004, CFA Institute • cfa pubs.org

De Coster: It is the same process for offshore and onshore administrators, especially because a lot of offshore administration is actually done onshore.

Question: Does it worry you if administrators are not third parties? De Coster: Experience has taught us to avoid some administrators just based on the way they operate. Some of these people have multiple jobs and have their hands in multiple pockets. It is important to make sure they are doing fund administration and that they are not doing something else on the side. Question: What has been your experience with terminating managers? De Coster: When we at ABS Investment Management terminate a manager, we like to do it face to face so that we can explain why we are taking the money out of the fund. In a few cases, we took money out and came back a year or two later after we thought the fund had cleaned up the areas of concern. That is rare, but it does happen. An investment is not always redeemed simply so we can allocate the capital to a different manager. Also, performance is not always the main reason why we get out. We understand a manager can have a tough environment and can underperform. Sometimes, we see things

we do not like, such as when managers run outside the boundaries of their stated investment strategies. In other instances, we might exit because the manager is having business issues or people issues. Finally, we tend to worry and may terminate a relationship if the manager’s assets are growing too quickly. A lot of managers become very large—almost to the extent that they become a new breed of mutual fund. It scares us to see a manager trying to run too much in assets or too many managed products. Swan: We believe it is very important to educate and create a partnership with our managers. It is about setting the appropriate expectation at the start of the relationship. We want them to have a good understanding of our expectations and why they are in the portfolio. That way, if we later decide to exit, it is easy to explain why. Question: Does there come a point where a plan or portfolio is large enough that the investor is better off building a hedge fund portfolio of its own rather than paying the additional fees involved with a fund of funds? De Coster: It is important to consider the resources necessary to do a good job; it is definitely a fulltime job. Moreover, if you are going to try and effectively build your own fund-of-funds portfolio, you must have good people running it and compensate them accordingly. Also, you have to be sure that there is a solid infrastructure in place. Having started a fund of funds 10 years ago, growing it to more than $3 billion, and starting a new one, I can say that the cost of running a fund of funds is about fourfold what it was a decade ago. Building infrastructure has become very expensive. For example, a decent hedge fund analyst with five or six years’ experience is very expensive.



If a plan is large enough to overcome these obstacles, that is great. But it must be prepared to devote significant resources to build the right infrastructure or it will hit a wall. Swan: The bar has definitely been raised over the past several years. Building a team with the right experience, tools, systems, and processes is a significant challenge. Institutional investors looking to go direct sometimes do not fully appreciate what is involved in evaluating, managing, and monitoring a significant fund-of-funds portfolio. Question: What is different about your job today versus five years ago? De Coster: What is different today is that hedge funds are in the limelight. When I started in the early 1990s, hedge funds were not mainstream. You could find hedge funds, co-invest your money with them, and build a great hands-on relationship. Now that hedge fund transaction fees generate the lion’s share of the prime brokerage revenues, even though they represent only 10 percent of the total volume of

transactions, it is a war out there. We are being bombarded by conferences, e-mails, and new managers that are lined up by the prime brokers. They throw a lot of names at us, and it is clear that their interests are different from ours. We want to get a great risk–reward ratio from our investment; they want to get a commission. The issue is that they have made the situation more difficult to evaluate than in the past. Prime brokers have predesigned presentations by strategy. When somebody comes to them and says “I want to launch a high-yield long– short fund,” they have the presentation for you. These guys have been taught the way to present to us, and often it is basically a prepackaged pitch. Consequently, people need more experience to evaluate hedge funds now than in the past because these guys have been much better prepared by the prime broker. Swan: It has certainly become more challenging to keep the infrastructure on par with the complexities of the business. Infrastructure must continually grow to keep pace. There is a higher emphasis


today on managing human capital and improving technology. Also, many hedge funds have a much better understanding of what is necessary to get an allocation from an institutional-quality investor and have devoted the appropriate resources. Question: What about hedge funds keeps you up at night? De Coster: Worrying about doing the best that I can keeps me up at night. I want to deliver the quality, service, and return that my clients expect. I want to make sure that we have the best possible organization and the best group of people. Swan: The things that keep me up at night are related to what I talked about, which is operational risk. Not enough people focus on the operational side of the business, such as processes, systems, and limitations. Frankly, those are the risks that end up generating headlines in the newspapers. Thus far, I have not found myself in that situation, but avoiding it is always on my mind.


The Hedge Fund Industry at the Crossroads S. Donald Sussman Chairman and CEO Paloma Partners Management Company Greenwich, Connecticut

The hedge fund industry has grown dramatically, and with that growth comes an increasing challenge for managers to find alpha. For investors, one key to finding good returns is to invest with hedge funds in the early stages of their life cycle; and one key to avoiding risk is to scrutinize a fund’s operational issues, such as the pricing of the book.

n this presentation, I want to make three main points. First, the rapid growth of hedge fund assets and managers will make generating alpha much more challenging, but not impossible. Second, the best way of capturing that scarce alpha will be to invest with hedge fund managers early in their life cycles. And third, whether investing with start-ups or more established hedge funds, investors must pay a lot of attention to operational risk in this asset class.

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Industry Growth The hedge fund industry is at a crossroads. What was once a tiny and arcane business is now a lot bigger and increasingly mainstream. Hedge fund assets under management grew from $36 billion in 1990 to $620 billion in 2002, according to Sanford Bernstein estimates. And the recent growth curve is even steeper. In Institutional Investor’s annual ranking of the 100 largest hedge fund organizations, the minimum assets under management required to make the list jumped from $645 million in 2002 to $1.4 billion in 2003. That is 117 percent in one year. That kind of growth is troubling to those of us who have been in the business for a long time. People frequently pay lip service to the problem of capacity constraints in hedge fund investing. But a personal perspective on how different this sector was when there was less capital and fewer players will provide a healthy sense of concern for the problem of capacity. When I first began working in hedge funds in 1981, this business was obscure, déclassé, and unpopular. I remember those days fondly. Only a handful of sophisticated hedge fund operations

©2004, CFA Institute • cfa pubs .org

existed, new managers were thrilled with $10 million or $20 million in seed capital, and opportunities to discover unknown market talent and inefficiencies were abundant. I do not want to suggest that it was a cakewalk to find successful hedge fund managers back then. It certainly was not. For example, Paloma was one of the early investors in quantitative statistical arbitrage. Although statistical arbitrage might seem like a conventional strategy now, many people at the time thought that high-volume computerized trading was science fiction. Nevertheless, the process of finding individual managers back then was relatively rational and deliberate. I remember back in the late 1980s I was trying to land a really brilliant individual to be a Paloma manager. As I recall, I was bidding against just one organization for his services, and it was a bank, not a hedge fund. I was offering this individual a lot of upside if he was successful but no guarantees. The bank was offering him less upside but a big guaranteed salary. My strategy was simple. I urged the prospective manager to consider the fact that if his statistical arbitrage trading model really did not work, the only logical thing would be to take—and lose—the other organization’s money. By today’s standards, I had a sure thing. Without question, the hedge fund business has gotten more crowded and less rational. In many situations these days, a hedge fund firm is going to be bidding against more than just one hedge fund for the most talented traders; as of 2003, more than $7.65 billion in dedicated hedge fund seeding or incubation CFA Institute Conference Proceedings • 43


capital was chasing new trading talent, according to InvestHedge. There are no two ways about it. This increased competition will hurt returns and make generating consistent alpha much more of a problem for the average fund. Having given this gloomy introduction, let me ask a reasonable question: Is this asset class close to being tapped out? My answer is no. I still see ample opportunities for extremely bright traders to systematically exploit inefficiencies in the markets. And no one can ask for more than that. Although it will be more challenging—a lot more challenging—I am confident that the best hedge fund groups will produce, with some consistency, superior risk-adjusted returns for their investors in the coming decade. In our relative-value corner of the hedge fund world, for example, there is a lot of buzz about the field of capital structure arbitrage. Capital structure arbitrage is the simultaneous buying and short selling of various securities of the same company to profit from mispricings between different layers of the company’s capital structure. It is an investment strategy that is highly complex, relatively new, and dependent on having expertise in many areas of finance and the capital markets. So, it is a strategy that we, and others, are anxious to explore. As always, it comes with its own set of risks, and whether it pans out in a big way remains to be seen. Risk and opportunities, of course, are all relative. If I were asked which is a more sensible risk-adjusted proposition in the next few years—a very smart quant hedge fund trader figuring out a way to wring returns from capital structure arbitrage trades or the stock market trending up from these valuation levels in this economy—I know what my answer would be. But the “right” answer remains to be seen. Some people think the hedge fund industry must be a bubble because of such factors as the extraordinary compensation earned by the top managers. I can understand that reaction, but it may be worth reconsidering. The best managers will always aspire to be compensated for their superior results in the asset management business. They desire to earn more money, to control their own destiny, and to see their own name on the door. These factors will not change. For those who believe in active management, it is important to concentrate on who, at the end of the day, can capture future alpha—even if it is somewhat less future alpha. I suspect, in general, that it will be some of the traders forming hedge funds, and I say that as someone who puts his money where his mouth is.

rule of thumb they learned in long-only investing and invest with hedge funds run by experienced managers very early in the life cycle of the funds. With apologies to veteran hedge funds, I believe very strongly in early stage hedge funds. I love their ferocious work habits, their style purity, and their focus. I think these qualities are very important to successful hedge fund investing. And I think these factors can be hard to find in more mature funds. Let me explain why.1 Hedge funds seem to follow a very common “life cycle.” Consider Phase 1 of that cycle. A talented and bright trader (whom I shall name Star) grows weary of the overhead and bureaucracy of a large institutional setting. The strategy he (or she) has traded has earned great risk-adjusted returns and appears to be successfully positioned to capture future alpha. Star might be hungry to earn more money and all the other perks I mentioned before, or Star might be the newly found moneymaker in a rapidly growing hedge fund where he or she earns less than what seems to be fair. With modest backing from a founding investor (relatively easy to get these days), Star leaves his or her firm and takes two bright quants and his or her core money-making team. With great diligence and adherence to their stated investment strategy, Star and his or her small team produce strong uncorrelated returns for their initial investors. Here is what I meant by reconsidering a longonly rule of thumb: Star at this point does not have a long performance record. And he or she may not have a lot of capital under management. Many institutions still have ironclad investment mantras or unofficial policies that would prevent or discourage them from investing with such a manager in spite of Star’s success. After several quarters of strong performance, however, money starts flowing in. Star is now within the decision set for most institutions. He or she has the requisite years of a track record and the “correct” capital under management. This is now Phase 2 of the hedge fund life cycle and the problems begin. The money starts to pour in, and the capital under management balloons. Soon, the trader team has grown to 10, maybe 20, or more. Operations and accounting are stretched or farmed out to a third party, such as a prime broker. The team starts allocating to new and different strategies (socalled style drift). Star is no longer exclusively trading as he or she was before; instead, Star is putting out administrative and personnel fires and going to investor meetings.

Life-Cycle Stages

1 Some

For those investors who decide to invest in hedge fund strategies, I recommend that they reconsider one 44 • CFA Institute Conference Proceedings

of my thoughts on this point have been inspired by data and ideas contained in a piece written by Byron Wien of Morgan Stanley in a May 2002 research report entitled “The Inherent Instability of Hedge Funds.”


The Hedge Fund Industry at the Crossroads

Phase 3 of the hedge fund life cycle soon follows. In part, the compensation structure of hedge funds is responsible for this phase, specifically the incentive compensation. If a fund is earning strong returns, the ballooning team will expect to be compensated handsomely. This compensation will need to come from the 20 percent carry the fund earns, which leaves Star, our founding trader, with one of two choices: either reward the traders well or be stingy. Assuming the latter occurs, if the firm has had a modicum of performance success, the 3 best traders (of the 50 now on the “team”) will go and start their own firms, leaving just Star and the less desirable team intact. This starts the life-cycle process anew for the three new Stars and leaves the longterm institutional investors with the remaining adverse selection of managers within the fund. The life cycle also starts anew when the fund performs poorly. Assuming losses occur, Star may continue to salvage his or her name and reputation, but the more talented members of the trading team will be anxious to jump ship and start anew without the yoke of the high watermark to make up. Do many hedge funds follow this life cycle? Absolutely. The dozen or so publications that cover the hedge fund industry spend much of their time just tracking the coming and going of traders from hedge funds. Analyzing Sharpe ratios, by both fund size and age, Byron Wien determined two very intriguing things in his report. First, the very best performance is found in medium-sized funds with between $25 million and $200 million in capital. Very small funds (less than $25 million) do better than large ones (more than $200 million). Second, Wien concluded that young funds tend to do better than mature ones. My experience coincides with Wien’s analysis. I believe the “sweet spot” of the hedge fund life cycle is found early on in the hedge fund’s career when assets under management are in the small to medium range. This is Phase 1 of the “life cycle” I described. Do some funds avoid the hedge fund life cycle problem? Absolutely. Unfortunately, the increased capital chasing hedge fund investments, which I discussed previously, will further compress the life cycle and exacerbate the problem. I know that my recommendation for investing with hedge funds earlier in their life cycle is quite a bit different from the way investors usually think about picking money managers. But some of the rules that apply to picking long-only managers just do not fit perfectly in hedge fund investing. If an investor wants to put together a stable hedge fund investment program for the long run, the investor must spend time thinking about these structural issues and must ©2004, CFA Institute • cfa pubs .org

challenge his or her hedge fund or fund-of-funds managers to deal with them.

Operational Risks If investors decide to allocate to hedge funds, they should scrutinize the operational infrastructure and internal controls of the managers. By operational infrastructure and controls, I mean everything from the valuation of securities to portfolio risk management to the checks and balances on simple wire transfers. Investors should understand the ins and outs of these controls. They should have lengthy discussions with the managers about all aspects of these issues. I know this is not exciting stuff. Who wants to talk about wire transfers when they can talk to traders? So, let me discuss the results of a study that might change some people’s minds. In 2003, a technology consulting firm called Capco analyzed 100 hedge fund failures over the past 20 years. It found that 50 percent of all hedge fund failures were caused by operational risk alone, rather than bad investment decisions. Of those operational failures, a very high percentage were cases of misappropriation of funds, pure fraud, or misrepresentation, which would include the mispricing of positions. The results do not surprise me. In some ways, the hedge fund industry has gotten a pass on the issue of internal controls. Because hedge funds were small operations, it was taken for granted that a lot of operational infrastructure would be outsourced or, worse, would be nonexistent. Unfortunately, that operating model leaves many funds, and their investors, with significant operational risk. The only way to mitigate that risk is to insist on old-fashioned internal controls. In other words, funds should have people watching the traders, and maybe people watching the people who are watching the traders. It is what banks do. It is what mutual fund companies do. It is not what most hedge funds do. Operational controls can be expensive, they can seem unnecessary in good times, and they can be difficult to implement in organizations where the real expertise is trading. But if investors do not insist on serious internal controls at their hedge fund and fund-of-funds firms, the level of operational risk they are taking on will be significant.

Conclusion The future of hedge fund investing, without question, will be challenging. And the new breed of hedge fund investors will have to find ways to deal with the unusual structural issues of the business. But I am confident that hedge funds will continue to reward diligence and creativity by managers and investors. CFA Institute Conference Proceedings • 45


Question and Answer Session S. Donald Sussman Question: Are there some types of managers or strategies that are better able than others to avoid the life-cycle process? Sussman: Very heavily quantitative strategies are much less likely to be vulnerable to life cycles. The strategies that are most dependent are ones where an important part of the value added to the alpha-generating process is really gut instinct and trading instinct. So, it is individuals who have those skills that are vulnerable to moving on to other places. Question: Over the past 25 years, have you developed specific characteristics that indicate “Star” to you? Sussman: There’s no formula for this. Identifying a Star has a lot to do with your instincts about the individuals involved. It has to do with history, track record, motivation, insight, seeing something different from what the other teams see, motivational reasons within the team members’ personal lives, and so on. It is much more a psychology test than it is a quantitative test, and so there is really no formula for it.

Question: Which comes first— strategy, asset class, or the personalities and the people? Sussman: It depends. If someone shows up and has a strategy that no one ever thought about and it is a completely unique insight into something that’s hedgeable in the capital markets, that’s very valuable even if the other factors are not all ideal. Question: Which operational metrics are important to look at? Sussman: From an operational standpoint, far and away the most important thing is who prices the book. That’s head and shoulders above everything. In many hedge funds, the traders price the book. And as soon as you hear that, you should be concerned. Think about it: They are counting on the people who are making their livelihood from performance to tell them how things are priced. In the long-only investing world, you don’t think of this as an issue because every stock exchange in the world gives you a closing price.


Question: If institutional investors will not invest with teeny and small managers, will that power a cycle where the industry will morph back into boutiques? Sussman: I think increasingly there will be methods for investing in small and medium-sized hedge funds, and I think the life cycle will just accelerate with the increasing amount of capital that’s available to start-ups. So, rather than working in a hedge fund for seven or eight years and then moving on to start their own fund, the managers will last three years. Consequently, the life cycle itself will speed up, which makes it that much more complicated for institutional managers. You might think you hired a class-A, blue-chip hedge fund, but then you find out that 80 percent of the team left over the past 18 months and the people who were trading your money and who you did your due diligence on are now running their own funds. So, it makes it quite complicated for institutional investors and very different from traditional asset management.


The Ten Commandments of Operational Due Diligence Robert P. Swan III Chief Operating Officer and Director of Due Diligence Lighthouse Partners, LLC Palm Beach Gardens, Florida

A well-defined operational due diligence process can help investors uncover risks and avoid the types of operational problems that can lead to a hedge fund blowup. Most issues begin with fundamental weaknesses of internal financial control, lack of separation of duties, and lack of support from top management for the firm’s operational infrastructure. Investors should look for an independent and segregated function that values the books and supports the operational infrastructure. Additionally, the firm’s management should be actively involved in the creation and monitoring of the firm’s control systems.

fter 10 years of being involved in managing hedge fund products, overseeing hedge fund operations, and performing operational due diligence reviews, I am glad to see that due diligence of hedge fund operations is receiving some focus from organizations as well regarded as CFA Institute. In this presentation, I want to provide a peek behind the curtain and describe some of the key components of how we at Lighthouse Partners follow certain processes and procedures when conducting our operational due diligence reviews. I would like to stress that if you take nothing else away from this presentation, please recognize the need for a sense of responsibility. One thing we investment professionals should do is make it our responsibility to continue demanding the establishment of an environment of compliance and controls among the hedge fund advisors to whom we allocate our clients’ capital. If we can create an environment that has more compliance and control as a standard, everyone will benefit: analysts, investors, advisors, and investment managers. Most managers will probably agree that taking losses from a calculated investment risk may be acceptable, or at least explainable, but taking losses from unidentified and unevaluated operational risks is clearly unacceptable. Unfortunately, these types of losses are usually the ones that make news headlines. In guarding against operational problems, understanding the work of auditors, administrators, attorneys, and other consultants is important. But those of

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us working in this area must go well beyond that. If we wait for one of those groups to catch operational issues, it will usually be too late. That is, we will be at risk of losing some of our clients’ money if we have not done our job ahead of time. Thus, we must delve into the key components of operational due diligence—the ten commandments of operational due diligence.

One: Define the Role Of all the hedge fund risks, operational risk has historically been given the least attention. Ten years ago, I did not hear much about defining the role, hiring a chief financial officer (CFO), or developing an operational due diligence process. Fortunately, I had some partners that recognized business and operational risks and supported my efforts. For a variety of reasons, such as the growth of institutional investment among hedge funds, other groups are beginning to focus more on operational risks. “Due diligence” is a vague term. As interest in operational due diligence grows and funds put together a team to focus on operational risks, one of the important things to do is to educate personnel about the role and responsibility of the operational due diligence function and empower this team with a proper level of authority. At Lighthouse Partners, we go to the extent of providing veto power to the operational due diligence team, thus enabling the team to hold back an investment that does not meet minimum internal financial control standards. CFA Institute Conference Proceedings • 47


Two: Define the Goal—Safeguard the Assets What is the main goal of operational due diligence? It is to maintain the highest possible level of safeguarding client assets. First and foremost, in an absolute-return category, if we are not preserving client capital by reviewing and evaluating operational risk, we are simply not doing our job.

Three: Define the Objective— Integrate Controls Consistently and Effectively Regardless of the different sizes and levels of resources within hedge fund operations, at a minimum, there has to be a consistent and effective integration of five key elements: decision support, trade execution, risk management, compliance, and accounting systems. Internal controls begin at the trading desk and end at the accounting and operations area, trickling down to the most detailed elements of accounting and operational control in hedge funds, such as daily cash, position, and P&L (profit and loss) reconciliation. If these controls are not consistently and effectively integrated, problems may arise.

Four: Segregate the Function The most significant weakness of internal control systems is their lack of segregation and independence. By some estimates, more than 50 percent of hedge fund failures relate to operational risks, with a primary contributor being a basic lack of segregation of accounting roles and responsibilities between the front office and back office.1 This segregation does not have to be complicated. Proper segregation often involves independent bodies doing simple things, such as independently valuing the portfolio and reconciling the books. These basic functions can usually catch most trade errors and rogue trader–type situations. Rogue traders are not going to show up in the trade room and tell everyone they are planning to steal. Obviously, rogue traders will work to conceal their actions. Putting basic policies and procedures in place and performing the appropriate walk-throughs can help identify these problems.

1

Data based on a March 2003 study by Christopher Kundro and Stuart Feffer with Capco (www.capco.com). The study is based on 100 hedge fund failures over the past 20 years.


Five: Do the Work On-site review of the operations function is critical and warrants more than lip service. At Lighthouse Partners, we focus on performing a significant number of manager interviews every year. Our investment analysts carry the burden of reviewing and evaluating a majority of the investment opportunities we look at each year, but no investment gets into our portfolio without an operational due diligence review. We make sure that we understand the corporate structure and service providers used, the key people and their backgrounds, the accounting process and controls, and the technology. We perform our review with the CFO or head of operations. If the accounting function is outsourced, we make sure that we understand the administrator’s role, frequency of involvement, process, and infrastructure because the administrators that have grown dramatically over the past four years represent as many potential problems as the hedge fund operations.

Six: Document and Communicate Effective and well-documented operational due diligence is the only way to benchmark and support the verification of an operational infrastructure. Additionally, educating the investment analysts about where to find weaknesses is necessary. Finally, documentation and communication help facilitate ongoing evaluation. A firm simply cannot perform one due diligence review, make its investment or trade, and not perform ongoing analysis. Solid documentation also helps us identify changes that may be making the firm susceptible to different risks going forward.

Seven: Work Efficiently with Investment Research Delivering a consistent philosophy to the investment team and educating them about business risks are important. Everyone must be the eyes and ears of the organization.

Eight: Remember the Fundamentals Investment due diligence is essentially irrelevant without adequately supported operational due diligence. The best trader in the world is useless without adequate and timely financial reporting, verification, and support for his or her investment track record. Conducting operational due diligence ©2004, CFA Institute • cfa pubs.org

The Ten Commandments of Operational Due Diligence

is the only way to ensure that the cash, position, and P&L reconciliations are occurring daily, going through the full cycle monthly, and being carried through properly to the financial reports that the firm gets monthly, quarterly, and annually from its auditors. If that information flow has problems or delays, then it is a serious red flag.

Nine: Note the Tone at the Top The common thread among significant losses in investment firms is the lack of appropriate senior management involvement. With some of the more noteworthy failures of the past, a system of internal financial controls was in place but management did not review it or sign off on it. Senior management should be involved in ensuring that a welldocumented policy and control manual exists and that it is actually in place and functioning.


Ten: Be Vigilant about Red Flags The red flags to look for are usually very basic, such as employee turnover, which often leads to the ability to circumvent controls. Other indications may include volatility of character and personality. Often, problems start with a lack of support for an independent operational infrastructure that is properly empowered. That situation can provide support for someone to potentially circumvent existing controls. Additionally, watch out for conflicts. An important step is to have the investment team interview the portfolio managers and document their story and then compare that story with the operational due diligence review. For example, as part of our reviews, we include a trading and risk management section that asks a variety of questions that get at the same basic things that our investment analysts ask. If we get different answers to those questions from the ones the investment analysts heard, it is a serious red flag.



Question and Answer Session Alain De Coster Robert P. Swan III Question: How do you feel about negotiating with hedge funds on fees? Are you believers in side agreements? Swan: It is a benefit to our clients to negotiate fees when we can. One of the reasons clients come to us is that we have generated the leverage in relationships over time and arrived at a position where we are often able to negotiate fees. The key is not to drive down fees to the point where we are not a partner with the manager. Rather, we strive to get to a point where we are in agreement as to what we are doing for each other. Some very successful firms will not negotiate fees. In those instances, a fund-of-funds manager just hopes to get capacity. So, without question, we take the opportunity when it arises to negotiate reduced-fee relationships because that directly benefits our clients. Question: Do you see capacity as a problem? De Coster: Capacity is definitely an issue. First, the number of analysts and the quality of their research are limited and can only be increased over time, so having managers with a clear understanding of what they can do with the current staff is important. Second, market liquidity comes and goes. And flexibility and liquidity tend to disappear at the precise time that managers need them most. The issue is further complicated by the fact that it is difficult to gauge exactly where capacity should be set. Managers obviously want to be prudent so that they will be in business five years from now. That said, there are always new people opening their

doors with new strategies and new opportunities. Swan: Capacity often follows the 80/20 rule. That is, the best managers are in the top 20th percentile, and that is obviously where you hope to find opportunities. Capacity also tends to follow a moving scale in that it cycles up and down based on changes in the equity, credit, and fixed-income markets. Fortunately, we are presently pretty excited about the opportunities we are seeing in the current hedge fund cycle. Question: Does it worry you when you hear about soft closes versus hard closes? Swan: I think closes are an important thing to monitor with hedge fund allocations. It is a problem when managers do not understand their capacity constraints and how they affect their ability to continue extracting an edge with their strategy or investment philosophy. When I meet with managers, it is a high priority to get an understanding of whether capacity will dictate a soft close or a hard close. If the manager claims he or she will hard close at a certain point and the fund later blows through that level, I want to know about it immediately and find out why the manager is still raising assets and whether it is supported by the opportunity set presented to the manager. Question:

How about liquidity?

De Coster: It is paramount that fund-of-funds managers ensure there is not a breakdown between the liquidity provided to their investors and the liquidity provided by the underlying funds they invest in. Some fund-of-funds


managers offer more liquidity to their investors than we do, but they are running a liquidity risk that can ultimately hurt their clients. We do not take that risk. Similarly, it is important to understand the liquidity of the underlying investments within the hedge funds in our fund-of-funds portfolios. The liquidity of those underlying investments should be in line with the liquidity that the hedge fund manager offers. Swan: Liquidity is certainly a key issue in hedge fund investing. We do our best to understand liquidity constraints and strive for a balance that makes sense. For example, if someone is operating in a distressed category and is offering monthly liquidity, that is a mismatch. We strive to understand the underlying asset class and combine those risks accordingly with the liquidity we offer our clients. Also keep in mind that liquidity varies in different stages of a hedge fund’s business. When a manager is growing dramatically and has consistent inflows, the liquidity picture is a lot different from when money stops coming in or when the manager stops taking assets. We make sure that we understand where a hedge fund investment is along that life cycle and the subsequent impact on liquidity. Question: Is there a correlation between funds willing to provide transparency and subpar performance? De Coster: I think the first thing you have to do is define adequate transparency. For us, transparency is not about knowing every single position held by every manager in our portfolio. Full transparency is ©2004, CFA Institute • cfa pubs.org

Q&A: De Coster and Swan

not the best use of time both for the manager and for us. Of course, we still do site visits to discuss large positions and concentrations in the portfolio. But we believe the key issue is to understand the portfolio structure, the risks, and how the portfolio changes over time.

Question: How do you assess offshore administrators?

Question: How often do you require net asset values (NAVs) from your managers?

Swan: The offshore administrators have been slowly consolidating onshore. So, we simply conduct the same analysis. We make sure that we understand the infrastructure. You have to do good work on both the manager and the administrator. You cannot count on administrators and auditors to find problems because they will ultimately point their fingers at the expert manager who is providing valuations.

Swan: Generally, it is difficult to get a full accounting close from hedge funds more frequently than once a month. At a minimum, we require monthly NAVs with independent documentation to support their valuations. We are fortunate to have good reporting relationships even with the fund managers that typically provide only quarterly reporting. Question: Do you have requirements for minimum track records or assets under management? De Coster: If you find a good manager but wait for a three-year track record, you are likely to discover that the manager is closed by the time you are ready to invest. Consequently, due diligence around issues other than the track record and assets under management becomes important so you can accurately gauge the quality, the valuation, and the future prospects. Swan: At one time, a three-year track record was our minimum requirement. But growth of the industry and competition for solid opportunities have pushed that requirement back. Consequently, vetting out other aspects of the manager’s history, such as background and reference checks, is all the more important. So, to answer the question, we look for a track record but are willing to accept situations where other substantive due diligence work indicates a solid opportunity. ©2004, CFA Institute • cfa pubs.org

De Coster: It is the same process for offshore and onshore administrators, especially because a lot of offshore administration is actually done onshore.

Question: Does it worry you if administrators are not third parties? De Coster: Experience has taught us to avoid some administrators just based on the way they operate. Some of these people have multiple jobs and have their hands in multiple pockets. It is important to make sure they are doing fund administration and that they are not doing something else on the side. Question: What has been your experience with terminating managers? De Coster: When we at ABS Investment Management terminate a manager, we like to do it face to face so that we can explain why we are taking the money out of the fund. In a few cases, we took money out and came back a year or two later after we thought the fund had cleaned up the areas of concern. That is rare, but it does happen. An investment is not always redeemed simply so we can allocate the capital to a different manager. Also, performance is not always the main reason why we get out. We understand a manager can have a tough environment and can underperform. Sometimes, we see things

we do not like, such as when managers run outside the boundaries of their stated investment strategies. In other instances, we might exit because the manager is having business issues or people issues. Finally, we tend to worry and may terminate a relationship if the manager’s assets are growing too quickly. A lot of managers become very large—almost to the extent that they become a new breed of mutual fund. It scares us to see a manager trying to run too much in assets or too many managed products. Swan: We believe it is very important to educate and create a partnership with our managers. It is about setting the appropriate expectation at the start of the relationship. We want them to have a good understanding of our expectations and why they are in the portfolio. That way, if we later decide to exit, it is easy to explain why. Question: Does there come a point where a plan or portfolio is large enough that the investor is better off building a hedge fund portfolio of its own rather than paying the additional fees involved with a fund of funds? De Coster: It is important to consider the resources necessary to do a good job; it is definitely a fulltime job. Moreover, if you are going to try and effectively build your own fund-of-funds portfolio, you must have good people running it and compensate them accordingly. Also, you have to be sure that there is a solid infrastructure in place. Having started a fund of funds 10 years ago, growing it to more than $3 billion, and starting a new one, I can say that the cost of running a fund of funds is about fourfold what it was a decade ago. Building infrastructure has become very expensive. For example, a decent hedge fund analyst with five or six years’ experience is very expensive.



If a plan is large enough to overcome these obstacles, that is great. But it must be prepared to devote significant resources to build the right infrastructure or it will hit a wall. Swan: The bar has definitely been raised over the past several years. Building a team with the right experience, tools, systems, and processes is a significant challenge. Institutional investors looking to go direct sometimes do not fully appreciate what is involved in evaluating, managing, and monitoring a significant fund-of-funds portfolio. Question: What is different about your job today versus five years ago? De Coster: What is different today is that hedge funds are in the limelight. When I started in the early 1990s, hedge funds were not mainstream. You could find hedge funds, co-invest your money with them, and build a great hands-on relationship. Now that hedge fund transaction fees generate the lion’s share of the prime brokerage revenues, even though they represent only 10 percent of the total volume of

transactions, it is a war out there. We are being bombarded by conferences, e-mails, and new managers that are lined up by the prime brokers. They throw a lot of names at us, and it is clear that their interests are different from ours. We want to get a great risk–reward ratio from our investment; they want to get a commission. The issue is that they have made the situation more difficult to evaluate than in the past. Prime brokers have predesigned presentations by strategy. When somebody comes to them and says “I want to launch a high-yield long– short fund,” they have the presentation for you. These guys have been taught the way to present to us, and often it is basically a prepackaged pitch. Consequently, people need more experience to evaluate hedge funds now than in the past because these guys have been much better prepared by the prime broker. Swan: It has certainly become more challenging to keep the infrastructure on par with the complexities of the business. Infrastructure must continually grow to keep pace. There is a higher emphasis


today on managing human capital and improving technology. Also, many hedge funds have a much better understanding of what is necessary to get an allocation from an institutional-quality investor and have devoted the appropriate resources. Question: What about hedge funds keeps you up at night? De Coster: Worrying about doing the best that I can keeps me up at night. I want to deliver the quality, service, and return that my clients expect. I want to make sure that we have the best possible organization and the best group of people. Swan: The things that keep me up at night are related to what I talked about, which is operational risk. Not enough people focus on the operational side of the business, such as processes, systems, and limitations. Frankly, those are the risks that end up generating headlines in the newspapers. Thus far, I have not found myself in that situation, but avoiding it is always on my mind.


The Hedge Fund Regulatory Environment Richard D. Marshall Partner Kirkpatrick & Lockhart LLP New York City

Interest in hedge fund regulation ebbed and flowed prior to the Canary Capital Partners hedge fund scandal. Regulators had concerns about the potential for fraud, conflicts of interest, and the marketing of hedge funds to unsuitable investors, but specific issues were not identified because of limited hedge fund oversight and tight U.S. SEC resources. The Canary scandal and others involving mutual fund market timing have brought a sense of urgency and focus to the U.S. Congress and the SEC. Consequently, a variety of legislative proposals and potential changes is geared to greater oversight of the hedge fund industry.

y goal for this presentation is to create a historical perspective on hedge fund regulation, leading up to where hedge funds stand today and what investors and managers might expect going forward. When I left the U.S. SEC about 10 years ago, the commission seemed to have little interest in creating new rules for hedge funds for a few simple reasons. First, resources at the SEC were stretched extremely thin. In fact, resources were so thin that the SEC was on a 40-year inspection cycle. In addition, the industry was relatively small. Moreover, most hedge fund investors are wealthy, sophisticated people for whom the SEC does not stay up all night fretting about such questions as: “Does this mean the DuPont family cannot take another vacation this year because they lost money in this hedge fund?” The theory was that these wealthy investors have lawyers and accountants to watch over their investments. The SEC was more worried about trying to watch out for the small retail investor. While I was with the SEC, I did actually bring a case against a hedge fund, but nobody had much interest in the case at the time. The hedge fund manager decided to retire, so he took the clients’ money and bought a house and a boat in Florida. I guess that could be called an extreme case of style drift. Of course, stealing clients’ money is frowned on by the SEC. So, aside from cut-and-dry fraud, such as committed by this Florida retiree, the SEC did not focus much on hedge funds except to clean up small regulatory glitches and, frankly, to make it easier for hedge funds to sell their services.

M


For example, a big study was done on the investment management industry in about 1992 while I was still with the SEC. The only thing I remember about hedge funds in that study was the idea of creating the Section 3(c)(7) fund, which came as an amendment to the Investment Company Act of 1940. Prior to this amendment and the creation of Section 3(c)(7) funds, hedge funds had an absolute limit of 100 investors and a complex body of law about how to count them. Ten years ago, a lot of people wondered why the SEC should even worry about the number of investors in a hedge fund. Why not let an unlimited number of very wealthy, sophisticated people invest? Let the whole DuPont family invest if they want to—thus the creation of Section 3(c)(7) funds. Then, in the midst of the Internet boom, the SEC issued a series of no-action letters. The most famous one was the Lamp Technologies no-action letter, which people read at the time as saying that it was possible to mass market to an accredited investor marketplace. Whether that was a fair reading is debated, but the point was to question why hedge funds had all these marketing restrictions.

Winds of Change A change in attitude began with the National Securities Market Improvement Act of 1996. That legislation dramatically cut down the number of advisors that the SEC was responsible for regulating. That legislation, coupled with some budgeting increases for the inspection side, meant that the SEC would be CFA Institute Conference Proceedings • 53


able to strike a better balance between its resources and the industry it was regulating. Ultimately, it pushed aside the notion that the SEC was not in a position to take on anything new. Consider that idea that the SEC could potentially take on new projects in the environment as it was in the 1990s. In 1997, when the Asian market had problems, the financial press ran several articles alleging that hedge funds exacerbated the situation. The core argument was that hedge funds had the capacity for broad macroeconomic impact but they could not be monitored because they operated with a lack of transparency. Of course, the meltdown of Long-Term Capital Management (LTCM) in 1998 was the issue that focused attention on hedge funds. LTCM was the sure-thing hedge fund run by super geniuses. It was the trading strategy that could not fail, but of course, it did fail. When LTCM failed, it was heavily leveraged. Eventually, it was discovered that a lot of banks and brokers also could have failed in LTCM’s wake if it were not for some intervention on the Fed’s part to ensure liquidity. As a result of the LTCM failure, some earnest talk began about regulation for hedge funds for two primary reasons. First, the secretiveness and lack of transparency behind which hedge funds operate mean that the U.S. government has no way of knowing what is going on, what these funds are investing in, or how they are doing. Second, the general perception was that hedge funds were growing larger and engaging in a high degree of leverage. The fear was that their ultra-aggressive investment style could potentially domino through the banking system and affect society as a whole. Frankly, the issue eventually died out. Investigation of LTCM revealed that despite all the geniuses in the world being assembled to come up with a foolproof trading strategy at LTCM, the strategy failed. Moreover, a lot of idiotic mistakes were made in recordkeeping, such as unsigned brokerage agreements and unsigned loan agreements. There was even an instance where a repurchase agreement was completely missing. It was just amazing. Nevertheless, the issue came and went. Clearly, hedge funds were growing strong prior to the LTCM failure, and then growth accelerated after the LTCM issue died out. A couple of reasons exist for this explosive growth. Foremost, I doubt that most people will find it shocking that performance fees make hedge funds an extremely profitable business. Second, because hedge funds enjoy tremendous flexibility in terms of leveraging and shorting, they produced solid performance while the equity market tumbled after March 2000. 54 • CFA Institute Conference Proceedings

Pre-Canary SEC Concerns Then, the darker clouds gathered again. Former SEC Chairman Harvey Pitt got the ball rolling. He had three concerns about hedge funds: fraud, retailization, and conflicts of interest. Fraud. Who is in favor of fraud? Of course, everyone worries about fraud, but two issues in particular were cause for special concern. One issue related to the valuation problem. Because of the opaqueness behind hedge fund operations, misrepresenting performance is relatively easy (i.e., it is easy to lie). Even more worrisome than the potential for misrepresented performance was what I refer to as style drift—taking wild risks that are inconsistent with what was promised to investors in the hope of making back money that was lost through poor investment decisions. Consider this hypothetical example. A hedge fund manager goes to Las Vegas and bets on number 17 at the roulette wheel. If he wins, he comes back with a big pot of money, puts it back in the fund, and nobody has to know he is a poor manager. The fraud gets covered up. Of course, if lucky number 17 does not come up, then the manager’s problem just got worse. Similar scenarios have occurred frequently enough to get the SEC’s attention. Retailization. Retailization refers to the growing concern that hedge funds are being marketed through a variety of means toward retail-type investors. A number of issues have led to this development. First, the solid performance that hedge funds posted during the equity meltdown meant that everybody wanted them. Second, some regulatory changes opened the door and made conducting mass-marketing campaigns easier. For example, the Lamp no-action letter that I mentioned earlier opened the potential for mass marketing to accredited investors. Third, the definition of “accredited investor” did not keep up with the times. The definition was created in 1982. Today, a much higher proportion of people can meet the accredited investor standard, thanks to years of inflation combined with a higher level of wealth in the United States. Of course, that increased investor base brings concerns about suitability to the forefront. I have seen a lot of cases where brokers inadequately addressed the suitability issue. One of my favorite types of cases relates to a 95-yearold patient on dialysis in a nursing home who is sold a hedge fund. What is the rationale? The investor needs that higher return, which could mean a lot in those final months in terms of quality of life. I do not think it takes a lot of homework to guess that the fund might not be suitable for this particular investor. So, ©2004, CFA Institute • cfa pubs .org

The Hedge Fund Regulatory Environment

even if the investor meets the accredited threshold by just a few dollars, selling him or her a hedge fund is a lot easier. Conflicts of Interest. The third major concern is related to conflicts of interest. What is particularly striking in this regard is that when one goes back and reads the statements that came out at the time regarding conflicts of interest, it becomes apparent that the SEC smelled a rat somewhere but was not sure where to look. The SEC was already concerned about IPOs. Say, for example, an investment advisor is running both a mutual fund and a hedge fund. Perhaps the advisor has a financial incentive to favor allocating IPOs to the hedge fund because of the performance fee. The SEC was concerned about that type of issue and did have a couple of enforcement cases in that area. But the SEC was not able to see enough into hedge funds to determine the scope of the problem. Another concern for the SEC was the potential for using hedge funds as a mechanism for getting around personal trading rules. For example, in one case recently, a hedge fund was owned by the employees of the firm and was not subject to the same trading restrictions that were in place for other firms’ funds. A particularly clear-cut instance of misusing hedge funds was the case in the late 1990s where a hedge fund was used to get around the rules that apply to brokers on handling customer orders. I worked on this particular case—the two dollar broker case. Two dollar brokers do not have retail customers; rather, they work on the floor of the NYSE. Essentially, they are independent floor brokers who execute orders for other exchange members. Because of the potential for floor brokers to take advantage of knowledge about customer orders, a rule states that floor brokers’ orders must be placed behind any customer orders. Some floor brokers set up a hedge fund as a client account that they were managing. The brokers were making the trades and investment decisions. The real problem was that an examination of the performance fees revealed that 90 percent of the profits were going to the two dollar brokers. The government alleged that the brokers were using a hedge fund that looked like a client account on paper to get around the rules about how orders should be handled. Unfortunately, although the SEC occasionally uncovered problems, such as with the two dollar brokers, it was not able to assess the magnitude or scope of these problems. Thus, it did not have a clear sense of which direction to move to uncover systematic problems. ©2004, CFA Institute • cfa pubs .org

The USA Patriot Act As the SEC was struggling to decide where to focus to get at the hedge fund issue, the September 11 attacks occurred. The rumor at the time was that Al Qaeda had used hedge funds to launder money to finance the terrorist attacks. I have not seen any proof of that belief, but at the time articles were saying that may have happened. Consequently, hedge funds were included in the USA Patriot Act. In addition to including hedge funds in the Patriot Act, rules have been proposed to apply antimoney-laundering standards to hedge funds. These rules have been sitting out there for a year and a half waiting to be adopted, so I will not go through them in too much detail. Basically, hedge funds would have to worry about two things. First, they would have to abide by the basic know-your-customer information-gathering rules. A lot of hedge funds are gathering this information already in anticipation of having to do it in the future. Second, and I think what is of the most concern to the hedge fund industry, is the proposal for some sort of national registry of hedge funds. Basically, the government wants some kind of registration because it cannot very well enforce the rules if it cannot determine who is operating hedge funds. Then, of course, once a registry is in place, it would not be a stretch to make hedge funds fill out a form ADV. It has been proposed, but not yet adopted. The Patriot Act says that those rules will eventually have to be adopted, so they probably will be applied to hedge funds at some point.

The Canary Era Another factor that brought hedge fund regulation into the news occurred when the most feared, the most hated, the most dreaded man ever to walk the earth, New York Attorney General Eliot Spitzer, decided to look into hedge funds. He was going to take a look at short selling. After all, hedge funds were selling stock they did not own and prices were going down, so there had to be some manipulation somewhere. The industry quivered as the Wall Street Journal’s “securities regulator of the century” dug in and investigated. Spitzer later announced that he had not found manipulation related to short selling. But just as the hedge fund industry began to sigh in relief, Spitzer did find something else—Canary Capital Partners. Canary was the conflict of interest that everyone was looking for. The conflict of interest that Canary engaged in centered on the market timing of mutual funds. The market timing, as it was allegedly conducted in the CFA Institute Conference Proceedings • 55


Canary case, resulted in Canary being able to capture the economic benefit of stale pricing. In essence, that style of market timing allows the timer to take money out of the pockets of the millions of investors who blindly pour their money into mutual funds. Their money was essentially transferred to the pockets of these billionaire hedge funds. Even at that level, one might think it would have been nice if the government had noticed this practice a bit earlier. What were some of the other things that Canary was doing? How did it get permission to market time? It went to the mutual fund companies and offered an economic benefit to induce them to allow market timing. Canary offered to invest some money in the mutual fund advisor’s hedge funds, and everyone knows how profitable hedge funds are because of those performance fees. So, Canary offered to put money into the mutual fund advisor’s hedge funds in exchange for being able to market time its mutual funds, which was the conflict of interest that the SEC had been watching for. That is what former SEC Chairman Harvey Pitt had previously been looking for but was unable to find. In this scenario, the hedge fund pays that wonderful fee to induce the fund company to allow market timing, which was, in many cases, prohibited by the fund’s prospectus and, in some cases, the fund company’s own internal policies. Moreover, the timing was viewed as injurious to those millions of hardworking Americans whose life savings were in those mutual funds. That blatant corruption is what is alleged to have happened with Canary. Of course, it only gets worse because Canary was also able to do two other things. First, at least in some instances, it was able to see the positions within the mutual fund portfolio that it was timing. In other words, Canary was given information well in advance of it being available to the mutual fund’s other investors. Second, and worst of all, Canary was able to engage in some late trading, which is clearly illegal. The laws on late trading have been as clear as a bell for many years. In fact, the Canary complaint, in what has become an almost famous phrase, says that Canary went out and corrupted the intermediaries, the brokers, and the transfer agents to let it put in the order at 10:00 p.m. and get the 4:00 p.m. price, which is the same as betting on a horse race after it is over. The Canary era would have been bad enough if Canary was the only problem found, but as Eliot Spitzer poked around, he kept finding more problems. Remember earlier when I talked about a hedge fund being used to get around personal trading rules? Well, Eliot Spitzer found that also. Pilgrim Baxter & Associates had a hedge fund that was allegedly used to circumvent the personal trading rules that other56 • CFA Institute Conference Proceedings

wise applied to Gary Pilgrim and Harold Baxter. Pilgrim Baxter & Associates claimed that the hedge fund was independent, but allegedly all, or at least a majority, of the money in the fund came from Mr. Pilgrim and Mr. Baxter. Moreover, they were allegedly telling the manager of that hedge fund where to invest. What was the hedge fund doing? It was market timing the very mutual funds that Gary Pilgrim and Harold Baxter managed. This particular case is still being litigated. I am not saying that the government will ultimately be able to prove these charges. I am pointing out this case because it is precisely the type of situation that the government is worried about with regard to a hedge fund being used to circumvent trading rules. Hedge funds have thus figured into the wave of mutual fund scandals in a number of ways. Number one relates to mutual fund market timing, and number two is the ability of hedge funds to induce other parties to participate in fraudulent behavior. In fact, according to Congressional testimony, a majority of market timing in mutual funds was done by hedge funds. That finding has a few implications. First of all, in November 2003, SEC Chairman William Donaldson expressed a desire to see increased regulation of hedge funds. He said that the SEC did not know what hedge funds were doing because they were not regulated. If they were regulated, the SEC would have been watching what they were doing and would have been more likely to detect and prevent this terrible practice of market timing mutual funds. Prior to Canary, enforcement cases tended to center on the special kind of “style drift” I mentioned earlier, such as outright taking the money and running or going to Las Vegas and betting on lucky number 17. But now, the SEC is seeing a whole new series of cases. Canary, and the subsequent market-timing scandals, has some significant implications for hedge fund regulation. In my view, this case will ultimately have a long-term effect on the way hedge funds are operated.

Where Are We Now? Chronologically, I am up to a 2003 SEC study whose basic recommendation is that hedge funds should be subject to SEC regulation.1 SEC Chairman William Donaldson went to Capitol Hill in November 2003 and said that the SEC might have found all this market timing if hedge funds were registered with the SEC. Everyone took that statement as a sign that 1

“Implications of the Growth of Hedge Funds,” Staff Report to the United States Securities and Exchange Commission (29 September 2003): www.sec.gov/news/studies/hedgefunds0903.pdf.


The Hedge Fund Regulatory Environment

Chairman Donaldson wants to bring hedge funds under the SEC’s oversight. Since then, the issue has gone back and forth in Congress. Considering Donaldson’s stance and the massive budget increases that the SEC has asked for, it certainly appears that the SEC is gearing up for greater oversight. In any case, the trend seems to be headed toward requiring hedge fund registration. In addition, some legislative proposals have resulted from the Canary scandal. Some of the proposals currently floating around are focused on the conflict of interest issue. At least one proposal calls for a complete separation of hedge fund management from management of any other type of account. That total separation is one way to solve the problem; the other way is through compromises that fall short of absolute separation of the industry. These compromises tend to focus on rule making, such as fire walls, reporting and disclosure, and restrictions on various types of activities.


Other issues on the horizon for hedge funds include the same fiduciary principles that are being articulated in the mutual fund market-timing cases. The cases against mutual fund managers purport to articulate the same rules of fiduciary duty and fraud that apply to hedge funds: All investors have to be treated the same way; there can be no selective disclosure, no special terms, and no waiving of agreements. Those principles apply in equal force in the hedge fund context.

Conclusion Spitzer has more cases in the works. He is continuing to sue people and bring attention to these issues. That activity keeps the pot boiling and Congress focused. It is a very volatile situation from a regulatory standpoint, and it will certainly lead to the identification of some new practices for the industry.



Question and Answer Session Richard D. Marshall Question: What are your thoughts about the relationship between hedge funds and investments banks? Marshall: The SEC looked at this issue and said it was going to monitor introduction services by investment banks— the introduction of potential investors to hedge funds. There is a kind of cycle that is created in the relationship between the prime broker and the hedge fund. The bigger the hedge fund and the more actively it trades, the more money the prime broker makes. Obviously, the hedge fund wants more investors. One of the issues that the industry is facing is there are only so many DuPonts and other accredited investors out there. Consequently, the race for dollars is heating up. That worries the SEC for two reasons. The first reason is simply that a dwindling supply of investors coupled with the profitability of the relationship creates an environment where brokers have a strong incentive to recommend hedge funds to investors who are not suitable for that type of investment. The second reason pertains to the appropriate application of the private placement exemption within Regulation D of the Securities Act of 1933. To avoid registration as an investment company, hedge funds are typically sold in private placements. The problem is that there is not solid agreement on exactly what constitutes a private placement. Twenty-five years ago, the private placement model was

based on a pre-existing one-on-one relationship between sophisticated wealthy people and advisors. In recent years, we have seen a lot of activity that pushes the envelope toward wider marketing efforts. Question: The SEC missed the boat on market timing despite the fact that all mutual funds have to be registered. Why would the registration of hedge funds carry with it the expectation that the SEC would do a better job? Marshall: The SEC did miss the market-timing issue. But although it missed market timing, it did find a lot of other things. Basically, if the SEC sees only one side of a trade, it is only 50 percent as likely to find a problem. So, requiring hedge funds to register would simply increase the chances of detecting problems. Question: If you were giving this talk three years hence, what would be the issues you would be discussing? Marshall: The real issue of the hour is how mutual fund scandals will resolve themselves and what statutory changes will result. Everything is going to depend on that. Ultimately, I think we are going to see the current scandals result in a changed landscape for investment management. One big change would be the possible creation of a self-regulatory organization (SRO) for the investment management industry. There are several benefits to having an SRO, starting with cost. An SRO would


cost the government nothing because the industry would pay for it. So, it yields greater oversight and more regulation without any cost to the taxpayer. That is pretty appealing given the huge budget deficits and the tough decisions that have to be made on how our nation’s resources are directed. Additionally, an SRO is nice because it is a nongovernmental regulatory entity, such as the National Association of Securities Dealers or the NYSE. That means Congress can beat up on them and blame them for everything; no elected official is accountable, which makes the SRO very appealing to politicians. The way that the accounting scandals of public companies were solved was by creating the Public Company Oversight Board—an SRO for the accounting profession. And we all know that the broker/ dealer world has its own SROs. Just about every entity that the SEC touches is in an SRO except investment management companies. Even if an SRO doesn’t come about, I believe the SEC is going to be, frankly, a much bigger pain for investment managers, partly because of the criticism that Spitzer leveled against them and partly because of its vastly greater resources. The SEC will likely be a lot tougher in terms of demands and deadlines. In turn, investment managers will need to have a lot more attention focused on compliance and a lot more money allocated to the compliance function.


Managing Legal and Regulatory Issues for Hedge Funds Gregory J. Nowak Partner Pepper Hamilton LLP Philadelphia

A hedge fund’s compliance program is about to become expensive. The U.S. SEC has been slowly, but surely, addressing several goals related to hedge fund activities. And legislation is on the horizon pertaining to the management of hedge funds that includes many new rules and that addresses compliance programs for advisors and investment companies. Moreover, many people misunderstand the numerous existing rules, such as those for selling hedge fund interests. Consequently, hedge funds must not fall into the trap of not knowing the rules but being held accountable to the standards.

eople frequently joke about the current regulatory environment for hedge funds, calling it the “Lawyers and Compliance Officers Full Employment Act.” In many respects, that sentiment is not far off target because a lot of issues and rules are being wrestled with right now. For this presentation, I will walk through a lot of the hot topics, such as the September 2003 hedge fund report and the compliance programs that the U.S. SEC mandated in its 17 December 2003 release. Additionally, I will discuss issues related to the selling of hedge funds, such as when and how hedge fund interests can be sold, as well as custody rules.

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SEC Staff Report The September 2003 SEC Staff Report “Implications of the Growth of Hedge Funds” contained seven goals.1 In the months following the report’s release, the SEC has been slowly, but surely, working through each of these goals. ■ Examine the activities of investment advisors to assist in evaluating issues related to market movements. This goal is basically a nice way of saying that if a firm’s name is in the newspaper on Sunday regarding the hedge fund empire that it is building in a particular locale, it should expect to hear from (and be audited by) the SEC on Monday. Why? The answer is that the examiner in the region wants to have an 1

This report can be accessed at www.sec.gov/news/studies/ hedgefunds0903.pdf.


answer when his or her boss in Washington asks about the firm in the newspaper. Quite simply, in 2003, the SEC was caught with its pants down; the U.S. Congress asked a lot of questions for which the SEC had no answers. Now, the SEC wants to assemble the data for the next time Congress has questions. ■ Provide investors with more current information about the operation, strategies, policies, and management of hedge funds. This goal simply means that firms should disclose, disclose, disclose. I have seen hedge fund documents that are as complete and as thorough as a mutual fund prospectus and the statement of additional information combined. Alternatively, I have also seen hedge fund disclosure that would fit on the back of a matchbook. The reality is that a happy medium exists, but firms should probably be erring on the side of beefing up risk factor disclosure and descriptions of the investment process. ■ Make investors’ due diligence of hedge funds substantially more efficient. In other words, as part of its goals, the SEC is proposing standardization of disclosure. It is coming. ■ Foster stronger compliance programs. This goal is addressed in the 17 December release, which I will discuss in more detail later. ■ Deter fraud and wrongdoing. Enforcement by setting an example has certainly been adopted as an SEC policy, and clearly deterring fraud remains one of the SEC’s goals.



■ Raise the standard for direct investments and hedge funds from accredited investors to qualified clients. Accredited investor standards are the familiar $1 million net worth or $200,000 or $300,000 of income for a single or joint return, respectively. That standard has been around for a long time. When it came out, $200,000 of income on a single return was a large amount of money. Of course, after years of inflation, those numbers are no longer the providence of the elite. Rather than go through the administrative process of amending Regulation D and everything else that goes along with it, some have proposed that the same result could be accomplished by looking through hedge funds, counting the number of clients in the fund, and forcing the advisors of those hedge funds with more than five clients or more than $25 million to become federally registered. At that point, the only way for the advisor to take a performance fee would be under the qualified client exception, which requires that the client have at least $750,000 invested with the advisor or that the client have a net worth of at least $1.5 million. ■ Permit hedge funds to continue their legitimate investment activities. Enough said.

H.R. 2420 In June 2003, the U.S. House of Representatives proposed H.R. 2420—Mutual Funds Integrity and Fee Transparency Act of 2003.2 If enacted into law, this legislation would essentially make it unlawful for an individual to serve or act as a portfolio manager or an investment advisor of a registered open-end investment company if such an individual also serves or acts as the portfolio manager or investment advisor of an investment company that is not registered. As drafted, the bill is a broad attempt to regulate the market with respect to the management of hedge funds. The bill seems pretty straightforward until one delves deeper into it. The good news is this legislation does not mean that a firm that is a registered investment advisor cannot manage hedge funds and 1940 Act funds in the same shop. In its current form, however, it does mean that a firm acting as a registered investment advisor will have to split the duties of its 1940 Act fund managers and its hedge fund managers. This splitting would hold true even if the hedge fund managers were running funds with a long-only bias that otherwise looked exactly like mutual funds except that they had lower fees and were directed to 3(c)(7)-type clients. 2

A summary of this act can be accessed at financialservices. house.gov/media/pdf/sect%20by%20sect.pdf.


A potential out does exist. The SEC may issue exceptions by rule, regulation, or order for exceptional cases where joint management is necessary to protect the interests of investors as long as there is enhanced disclosure to open-end fund clients and there are fair and equitable policies and procedures in place for the allocation of security trades among the client accounts of the advisor. Of course, many of this bill’s issues remain open as it stands today, and a lot of people are speculating on how various potential conflicts would be addressed. The wise thing to do is to wait and see if the bill passes before making any radical changes, but firms should be prepared to have some kind of system ready to make it work.

SEC Release IC–26299 On 17 December 2003, the SEC released IC-26299— Compliance Programs of Investment Companies and Investment Advisors.3 I recommend that all advisors wade through the release because it may contain “kill the fly with a sledgehammer” rules. I will review some of the bigger issues, focusing on those that affect advisors. Compliance Policy and Program. Foremost, advisors must realize that failure to comply with IC26299 will be considered an independent violation of the securities laws. In other words, failure to have an adequate compliance policy is no longer a derivative fraud violation for issuing a bad security under the 1934 Act Rule 10b-5 or some other provision. So, not having an adequate compliance program in place will be considered an independent, personal violation of the securities laws. The SEC specifically said it is not going to mandate “how to do anything” (i.e., how advisors should build their compliance programs, what they should contain, and how they should be operated). Rather, it is simply going to require that firms determine their own best practices. The standard approach is to do a self-assessment and identify conflicts and compliance factors creating risk exposure for a firm and its clients in light of its particular form of organization. The next step is to design policies to address those risks. The specific rules and how situations will be judged are up in the air. So, everyone will have to use their best judgment and common sense with the objective of going back to the SEC’s seven goals I mentioned earlier. That is, think about what the SEC is trying to accomplish with all these rules. 3

This release (the Investment Company Act Release No. 26299) is also known as the Investment Advisers Act Release No. 2204 and can be accessed at www.sec.gov/rules/final/ia-2204.htm.


Managing Legal and Regulatory Issues for Hedge Funds

Ultimately, a firm does not need a massive binder (with policies that no one looks at or uses), but it better have all the necessary elements. Not every action that is taken needs to be memorialized so long as there is accountability. The responsibility to take action should be allocated within the organization to one or more persons, and fault/decision lines must be clearly identified. At a minimum, the compliance policy and program should adequately address the following elements: ■ Allocation of investment opportunities. Paul Roy, one of the division chiefs at the SEC, has talked many times about the issues that arise in the allocation of securities among accounts. A rational basis must be used for those allocations among accounts. Moreover, that allocation of investment opportunities must be consistent with the portfolios’ and the clients’ investment objectives. ■ Trading practices. The compliance program must address proprietary trading of the advisor and personal trading activities of supervised persons. Additionally, it must be sure to cover procedures by which the advisor satisfies its best execution obligation, uses client brokerage to obtain research and other services, and allocates aggregated trades among clients. In other words, it must make sure it is not using soft dollars for anything other than pure research. ■ Accuracy of disclosure. The compliance program must have systems in place to ensure the accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements. ■ Records. The compliance program must address the accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration and protects them from untimely destruction. In other words, do not bother telling your friendly regulator that the dog ate your homework or that it was shredded—accidentally. ■ Marketing of advisory services. The compliance program must have in place certain rules with respect to its marketing department to make sure it does not violate solicitation rules. ■ Process of valuing client holdings and assessing fees. Most of the recent abuses have come from aggressive pricing policies and procedures. A firm must look at its disclosure and match it with its actual procedures. The compliance program must make sure that the firm prices securities the way it says it prices them in its private placement memorandum (PPM) or offering memorandum. Just as important, if the firm does not say anything about how it prices securities, it should think about whether not addressing that topic makes sense. ©2004, CFA Institute • cfa pubs.org

■ Business continuity plans. September 11 is still on everyone’s mind, so the compliance program should address continuity plans. Annual Review. The 17 December document also identifies annual review of compliance policies and procedures for advisors. Registered investment advisors must review all policies and procedures at least annually and more often if a change takes place in law, personnel, or operations. And firms should be sure to consider the impact of mergers and acquisitions on their operations. In this case, I am not necessarily talking about going out and doubling the size of the firm or being acquired. Rather, the change could be simpler, such as the lift out of a team. As a firm changes, it needs to ensure proper integration of the trading desk with compliance and conflict checks. If these functions are not integrated, the firm should be sure that the proper firewalls are in place between different account types (hedge funds, mutual funds, separate accounts, etc.). Then, the fees and expenses must be shared appropriately among the divisions of the organization. CCO. Registered investment companies must appoint a chief compliance officer (CCO). Thus far, the SEC has not specified the same for hedge funds, but registered advisors (whether they manage mutual funds or hedge funds) must have a CCO. The first requirement for this CCO, and everyone laughs at this requirement, is that he or she be competent. The CCO cannot be a pushover; that type of CCO is not going to cut it anymore in this environment. The CCO must also be knowledgeable about the Investment Advisers Act of 1940. This person does not have to be a lawyer or paralegal but should definitely be someone with significant experience and an understanding of the intricacies of the Advisers Act. Additionally, the CCO must be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures, including calling out the CEO in front of the board of the advisor, the board of the mutual funds, or even the SEC if necessary. Best Practices. First, if not already in place, a firm must appoint a CCO for the advisor immediately. Additionally, it should consider appointing a CCO for its hedge funds, even if it is the same person as for the advisor. Doing so is not yet required, but having a CCO establishes separate lines of authority, which is something firms definitely want to consider. Second, firms should engage in effective introspection, reflection, and ratiocination. In addition, firms should review trading and compliance procedures in light of the SEC’s hedge fund industry report CFA Institute Conference Proceedings • 61


“The Implications of the Growth of Hedge Funds” and the 17 December 2003 compliance release. That is, firms should ask themselves the following: What is our business? How does each business practice drive our business? What issues and risks does each business practice present? What safeguards are in place now, and what additional safeguards are needed? Who reviews periodic reports and how often? Are records kept? Third, firms should consider a top-to-bottom compliance review to set a baseline, especially in merger and acquisition transactions. Again, this step is not required, but if an advisor is in a fairly large organization or one where the players have come together just recently, taking a step back and doing some of that ratiocination makes sense to ensure that all these issues are being considered.

Selling Hedge Fund Interests At this point, I am going to shift gears and discuss the selling of hedge fund interests. These rules have been around for a long time, but they tend to be forgotten. I will go through the rules at a high level, discuss some of the basic do’s and don’ts, and address the consequences of violating the rules. The 1940 Act and the Conditions for Exemption. Hedge funds are not registered investment companies. For a 3(c)(1) fund, one of the key elements for exemption from registration (under the Investment Company Act of 1940) is to have 100 or fewer investors and conduct no public offering. That requirement is written right in the statute. Funds that are 3(c)(7) funds must have 500 or fewer qualified purchasers and, again, may not conduct a public offering in order to be exempt from registration. NonU.S. funds in the United States do not get a free pass. They must meet the definition of a 3(c)(1) or a 3(c)(7) fund with respect to their U.S. investors or they will have to register under the 1940 Act, if they can. That means that they too cannot engage in a public offering or solicitation of their securities. Of course, the natural question becomes: What is a public offering? Generally, a 1933 Act registration is viewed as a public offering for 1940 Act purposes per se. What I mean by that is that if a fund has registered under the 1933 Act, the jig is up; it is making a public offering. If Regulation D is used, however, then the issuer (namely, the fund) must limit its sales to persons with a pre-existing relationship, which we often call the “friends and family” exception. Now, the reference to “friends and family” is just a rule of thumb. What is really being addressed is a suitability test. The advisor must sufficiently know the person to whom he or she is intending to sell so 62 • CFA Institute Conference Proceedings

that the advisor can form a reasonable position as to whether that person is capable of sustaining the entire loss of his or her investment in the fund. The prohibition on public offerings includes a ban on general solicitation and advertising of hedge funds. What is a general solicitation? Well, it is not defined, so advisors must trust their common sense instincts and not try to cut it too close. Everyone would agree that sending a blast e-mail out to a gazillion people would be considered a general solicitation. The common notion exists, however, that sending out an e-mail to 500 people is OK. But unless the hedge fund manager has 500 close friends and family about whom he or she can form a personal conclusion that they are capable of sustaining the loss of their entire investment, then that e-mail would also be viewed as a general solicitation. What is the general rule? Again, a pre-existing relationship must exist between the hedge fund or its broker/dealer and the investor, and the investor must have sufficient time to evaluate the risks and merits of investing in the hedge fund. Many times, especially with new managers, I have gone through this litany and told people what they cannot do. By the time I am done, they are usually exasperated and ask how they are supposed to sell their funds. Of course, a fund can be marketed in a variety of ways. Following are permissible solicitation activities, drawn from various no-action letters, exemptive orders, and other pronouncements from the SEC: • Mail a PPM and an offer letter for a new fund to investors in other funds sponsored by the advisor (i.e., cross-selling is OK). • Mail a PPM and an offer to the executives of the advisor. It seems commonsensical, but it took a no-action letter for the SEC to agree with the permissibility of this practice. • Mail a letter and a questionnaire to a small number of business and professional persons, the sole purpose of which is to determine their suitability as investors in private funds. The materials may not, however, contain any reference to a particular private fund. So, the first step is to collect information about a pool of people. If they return that questionnaire, a relationship can be built. And after some time has passed, they can be contacted to confirm that they are qualified investors. • Offer the fund to clients of a broker or placement agent provided the clients have a true pre-existing relationship with the broker or agent. In other words, bucket shops are not a good deal. • Solicit investors under small private offerings that are exempt under state law or where state law requires delivery of a prospectus as part of the sale. ©2004, CFA Institute • cfa pubs.org


•

Use finders, provided they do not engage in a public solicitation. Advisors may not rely on a finder’s determination that the investor is qualified. If there is any controversy today, it is on this point. So, what are impermissible solicitation activities? • No mass mailings to a class of investors— advisors cannot send mass mailings regardless of how they get the mailing list. • No mass mailings or brochures to broker/dealers, investment advisors, accountants, or attorneys who have no pre-existing relationship with the advisor. • No mass mailings to persons who have no preexisting relationship with the advisor—I cannot stress this point enough. Best Practices for Solicitation. I strongly urge advisors to keep in mind the SEC’s list of solicitation factors, which are those things that the SEC considers when evaluating solicitations. ■ Rational basis. The advisor must have a rational basis for choosing the offerees. The rational basis must be an outcome from a pre-existing relationship with a qualified investor. ■ Sophistication. The offerees must be able to fend for themselves and not rely on a placement agent or someone else to help them. ■ Pre-existing relationship. The nature of the pre-existing relationship should be clear. I have a helpful tip: Evidence of serious, direct negotiations between the issuer and its offerees has been well received by the courts as evidence of a sufficient preexisting relationship. ■ Time. A sufficiently long period must pass between the first contact with the offeree and the first actual offer of securities. One day is not going to cut it. One month might do fine. Where is the line? Advisors have to use their own judgment and develop a feel for it over time. ■ Nature and quality of information. The nature and quality of the information provided to the offeree should be beyond reproach. The advisor should be careful not to presell the offering prior to delivering the PPM. Remember, anything given to offerees will be held against the issuer by the offeree if something goes bad. The worst of all possible worlds is to sell something without a proper disclosure document because the risk of rescission exists. Of course, rescission is only an issue when the value of the investment is going down. ■ Number of offerees. The number of offerees is not an overly critical factor after the Supreme Court’s decision in SEC v. Ralston Purina in 1953, where the court focused more on the nature and characteristics ©2004, CFA Institute • cfa pubs.org

of the offerees than on the manner of the offering.4 Nevertheless, the number of offerees may still be considered relevant evidence of the intent of the parties. A fund can rarely build a case for exemption if it has a substantial number of offerees. If a fund has e-mail traffic showing thousands of offerees, the exemption is just not going to fly. ■ Investor questionnaire. The investor questionnaire was once used, reviewed, and accepted as part of the offering process. Funds should not skip this part of the process. When funds short circuit the process, they run into trouble, fall under scrutiny, or get brought up on charges. Permissible Advertising. The ability to advertise a fund is fairly limited, but a few permissible advertising activities do exist. For example, posting performance and other fund information on a thirdparty website is OK provided that the site and all access to it are password protected, the site is available only to accredited investors, and there is a 30-day waiting period between the date of determination of qualified status and the first purchase. The SEC is still coming to grips with cyberspace and how websites work. Consequently, it keeps trying to put things back into the paper mold. Nonetheless, some of these restrictions make sense. If people sign in to the website and give their information, the fund should not be able instantly to sell to them because it has not been able to determine whether they are suitable investors and whether they are making this investment after sound reflection. Another possibility for advertising is the use of tombstone ads. I personally think they are useless, but a lot of people like to use them. Certainly, newspapers love it when people spend thousands of dollars for ad space. Of course, some restrictions do exist. An ad can be placed only on completion of an isolated offering, essentially saying so many millions of dollars of X, Y, and Z have been placed and giving the name(s) of the placement agent(s). Another restriction is that the fund that is the subject of the ad may not maintain an ongoing offering of its interests. Finally, no offering of the fund or a similar fund waiting in the wings can be made in the ad. Another alternative is to advertise other services of the advisor, but the advisor must not drift into selling securities: It is the selling of securities that makes it a violation of the law. Similarly, issuing a press release about the advisor or its business, such as announcing a new partner, is OK provided that it is not just a pretense and the fund is not mentioned or promoted. 4 SEC

v. Ralston Purina Co., 346 U.S. 119 (1953).



Impermissible Advertising. Technically, everything is impermissible except what I mentioned as allowable, but certain things are absolutely, positively verboten: • an ad in any medium, including trade journals, that mentions the fund (the exception being the tombstone ads that I discussed earlier), • communications about the fund on TV or radio, • seminars or meetings about the fund where the attendees are invited by a general solicitation or advertising, • ads generally seeking investors for private funds even if the fund is not mentioned, and • ads in foreign general circulation newspapers offering fund interest for sale with the hope that the paper will find its way into the United States (e.g., an ad in the Toronto Star with the hope that the paper will make its way into Buffalo, New York).

NASD Regulation If complying with the SEC’s rules and state regulators’ rules is not hard enough, funds also have the National Association of Securities Dealers (NASD) watching over them. In selling a hedge fund, the fund might think that it does not need to worry about the NASD if it is not a registered broker/dealer. But it should be aware of the NASD’s rules to avoid the possibility that the NASD deems it to be acting in a broker/dealer capacity without being registered, which is a violation in and of itself. If private placement agents are used and they are registered brokers, and of course they all should be, the fund must make sure that it is not asking the agents to do something that is in contrast to their requirements under the NASD. One item to be aware of is Rule 3a4-1, the issuer’s exemption. Many people do not truly understand what this provision means, or they forget about its limitations and subsequently abuse it. The fund can sell interests in itself directly to the public but not in a general solicitation without being considered a broker. Employees of the fund and related persons, such as employees of the advisor or the general partner, may be brokers and may be required to register as broker/dealers with the NASD if they are paid for selling securities (i.e., they receive commissions and they have few other duties aside from sales). Another point to keep in mind is that securities themselves may be exempt under Regulation D but the salespeople may not. If a person sells Regulation D securities and another exception does not apply, such as the issuer’s exemption, the salesperson himself may be required to register as a broker/dealer. 64 • CFA Institute Conference Proceedings

Then, of course, there is the finder versus broker tightrope. When is someone a finder, and when has that person crossed the line into being a broker? If the finder’s activities are limited to making an introduction and then the finder steps out, that is OK. But finders should not preclear or prequalify people. The NASD also has something to say about the promotion of hedge funds. The description of the potential advantages of the hedge fund investment must be balanced by fair presentation of the risks and potential disadvantages of hedge fund investing. If the fund uses leverage, then that fact must be disclosed by the private placement agents along with the disclaimer that such leverage will increase risk. And disclosures must be made about such factors as illiquid interests, complex tax structures, delays in reporting taxes, and high fees and that periodic pricing or valuation information is not required by the fund or otherwise is not available. Something else to be aware of is reasonable basis suitability. NASD members must have a belief that the product is suitable for their investors. The NASD member must perform substantial due diligence on the fund, or the underlying funds in the case of a fund of funds. This due diligence would include background checks on the fund managers, review of all documents (e.g., PPM, LP/LLC agreements, subscription materials, and references), and review of the fund’s relative performance.

2003 Amendments to the Custody Rules Exactly what constitutes custody depends on the business to which one is referring. In the context of the advisory business, custody is directly or indirectly holding an advisory client’s funds or securities or having any authority to obtain possession of them, which includes possession of client funds or securities unless they are inadvertently received and returned within three days. Custody also includes the authorization to withdraw client funds or securities maintained with a qualified custodian upon instruction to the qualified custodian. Every investment advisor under an investment management contract is affected by that last point. If you, as an advisor, have authority to move money, then you may have custody. Likewise, someone who is a general partner of an LP, managing member of an LLC, or in a comparable position in a pooled investment vehicle or trust and who gives the advisor or the advisor’s supervised person legal ownership of or access to client funds or securities is deemed to have custody. ©2004, CFA Institute • cfa pubs.org


The use of affiliates is ineffective to avoid custody, but authority to issue instructions to a broker/dealer or custodian to effect or settle trades does not constitute custody, nor does receipt of a fee “check” or helping clients compile documents, such as subscription agreements. Qualified Custodians. Recently, some banks said that in order to meet the custodian rules, they would have to set up custodian accounts; they would not allow a simple demand deposit or some other bank account. Clearly, a safe deposit box at a bank does not work, but putting cash of the fund in a checking account does work. The account does not have to be a bank “custody” account with higher fees. The SEC has again made that point clear. Of course, prime brokerage custody is perfectly OK, and some futures commission merchants can be custodians, as can foreign financial institutions under certain circumstances. Best Practices for Separate Accounts. For advisors managing separate accounts, those accounts have to be maintained with a qualified custodian. Advisors must also have a reasonable basis for believing that the qualified custodian is sending out quarterly account statements to each client. If the custodian is not sending out those statements, then the advisor must handle the task. Also, for separate accounts, if the advisor sends out the statements, the advisor must undergo a surprise annual audit, including both an asset valuation and an income and expense audit.


Best Practices for Single-Strategy Hedge Funds. Single-strategy hedge funds are required to place the assets of the fund with a qualified custodian. They are not required to provide quarterly account statements via the qualified custodian if the entity is a pooled investment, such as a limited partnership, LLC, trust, or similar vehicle; transactions and assets of the pooled entity are subject to an annual audit; and annual audited financial statements are distributed to each limited partner or member within 120 days of the fiscal year’s close. Yes, that practice conflicts with the Commodity Futures Trading Commission’s 90-day hard deadline, but as everyone knows, advisors can normally get an extension of that deadline to 120 days. Best Practices for Funds of Funds. With a fund of funds that holds privately offered securities, namely, underlying hedge funds, the fund of funds does not need to place the assets, other than cash, with a qualified custodian if the securities are privately held by the fund of funds and if they were acquired from the issuer. Additionally, best practice for a fund of funds is for the securities to be uncertificated and transferable only with consent of the issuer. Furthermore, the LLC or LP should be audited annually, and the financial statements of the LP or LLC holding the securities should be distributed within 120 days.



Question and Answer Session Gregory J. Nowak Question: What do you think the likelihood is that H.R. 2420 will be enacted as currently written, and what is the timing? Nowak: If there is another scandal involving a hedge fund, H.R. 2420 will most definitely be enacted in this session of Congress. But if we all keep our heads down and avoid getting into the mutual fund noose, there is a very strong possibility that it may cave in on itself. I think people realize that you don’t necessarily need to legislate the separation of the two businesses to have a strong compliance system. Question: Do you think the increased standard from accredited investor to qualified investor is going to be retroactive? Nowak: To my knowledge, no. Remember, this is just an SEC staff recommendation. It has not been enacted by rule, and it has not even been proposed as a rule yet. But from what I have seen so far, the SEC has rationally been applying these new rules, such as the custody rule. The rules have been applied on a prospective basis with fairly lengthy grace periods to come into compliance. If the SEC decides to increase the standard from accredited to qualified investor, I think it will follow the same pattern. Question: What are the restrictions placed on a consultant who

does not manage money and is acting as an agent to sell a fund? Nowak: Regardless of what the consultant calls himself or herself, the reality is that if the person is engaging in brokerage activity, vetting possible purchasers of your product, or receiving a broker’s compensation or commission, then more likely than not, that person is acting as a broker, consultant label notwithstanding. Question: If there is no sales commission and no payments for selling a Regulation D fund, then can it be construed as a public offering? Nowak: There are many collateral consequences to taking a Regulation D offering to a public offering. Through the confluence of tax and securities laws, you might find that all of your funds are taxed as partnerships whether they are formed as LLCs or something else. Once a fund becomes registered, the immediate default position, unless you put in a lot of firewalls, is that it is a subchapter-M company and subject to taxation under subchapter-M. This means you would have to pay dividends on 90 percent of your income to retain your flow-through status. You also have a fixed-diversification rule for tax purposes. You can be nondiversified for SEC purposes, but four times a year you must be diversi-


fied for tax. You would also need to deal with all the compliance rules under the 1940 Act. Because of all these consequences, I would not suggest taking a Regulation D offering to a public offering. Question: What is the biggest regulatory risk faced by funds of funds? Nowak: The biggest risk revolves around “tree topping” your expenses and not giving disclosure of your investment and valuation processes for the underlying funds. It comes down to a disclosure issue. Should investors know what your total expense ratio is from top to bottom, including the underlying hedge fund expense ratios? More important, should you be disclosing the investment processes and holdings of those underlying hedge funds? Today, that information is typically considered to be proprietary and the data are not disclosed. In this situation, you face (1) a lack of understanding about how these things work, (2) a lack of understanding about the economics of the arrangement, and (3) fear of the unknown or an expectation that there is something underhanded. That can lead to a compliance nightmare where the investment process, holdings, and top-to-bottom fees would have to be disclosed.


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