Mr Banfield founded and was Chief Investment Officer of a Canadian hedge fund from 1997 until 2002. During this time, the fund generated a compound annual return of 34%, never had a negative year, never a negative quarter. Prior to running the hedge fund, Mr Banfield worked for 10 years in proprietary trading at two Canadian investment banks.
An important point hedge fund managers should keep in mind is that the best investors don’t want to micromanage their managers. Integrating the following points into the framework of a hedge fund will greatly improve a fund’s appeal to institutional and high-net-worth investors. These points are often given equal or greater consideration to performance, as these guidelines will help to prevent problems in the future.
1. Liquidity and integrity
If your fund accepts money monthly, then it should provide liquidity monthly. Not all requests for redemption are based on unsatisfactory performance. Giving investors the opportunity adjust their exposure to a fund within a reasonable timeframe is essential for managers trying to convey the message that they are able to manage liquidity risk in the portfolio. Most funds these days have market disruption clauses that provide the manager with the option to restrict redemptions during times of severe market duress. Investors want this clause, as it helps to reduce volatility. However, for a manager to need more than 20 days to generate 10%, or even 15%, cash during properly-functioning markets is absurd. A long notice of redemption period is a huge red flag to investors. It says a large proportion of the fund’s investments are illiquid and, therefore, carry an elevated level of risk. In today’s world, a hedge fund manager definitely wants to avoid being labeled illiquid at all costs.
2. Information on a timely basis
Hedge funds should provide investors with timely month-end net asset value (NAV). Estimates within seven days of month-end are no longer a challenge, and are becoming an indicator of how strong a fund’s internal controls are. Providing investors enough time to make informed decisions as to whether any changes to their holdings are warranted is essential to attracting good investors. Today, prime brokers provide their clients
3. Fairness for all
In business, it is common to have penalties levied when commitments are broken. Investors agree to invest their capital based on the terms provided in the offering documents. The terms will often stipulate a minimum hold period. The same material often provides a targeted return and volatility the fund will generate. If the hold period is violated, a penalty is imposed by way of a redemption charge. This is acceptable, as long as the manager has also upheld their commitment to generate the targeted return and volatility. Simply put, from the perspective of the investor, if the funds performance is negative over a reasonable period of time (eg, six to eight months), or the fund experiences abnormal volatility swings relative to its historical relationship to general market volatility over a similar time frame, then the investor should be entitled to redeem without penalty, as the manager has failed to uphold their commitment.
4A. Alignment of interests
It doesn’t get much simpler than this; an individual confident enough in their investing skills to tie their compensation to the performance of a fund should be confident enough to leave the majority of the compensation in the fund going forward. Investors have been outraged by managers who received huge amounts of money as the value of their fund went up, but lost little of that money when the same fund dropped substantially in value. If it’s ok for hedge fund managers to be partners in the gains of a fund, then they must be willing to maintain that relationship during times the fund suffers losses. In order to accomplish this, managers should only be paid a portion of the performance fees annually, and the remainder paid when either an investor’s capital is redeemed, or the partnership is dissolved entirely. If the manager feels that under this structure, his capital is excessively exposed to risk during the life of the fund and wishes to reduce the exposure, they can return a portion of the capital under management back to investors and receive the unpaid performance fees on that capital. Alternatively, if a manager is concerned about the level of risk their wealth is exposed to in a certain market environment, then they can move capital to cash, therefore, reducing the risk to all investors. Managers that align their interests with investors by paying out all fees but reinvesting a portion of the after-tax proceeds of their compensation in the fund are not exposed to the same level of risk, and any graduate of sixth grade math knows this. To imply otherwise is insulting to the investor.
4B. The good investors want their managers to be properly paid
Good investors don’t want money management decisions influenced by the manager’s need to pay bills. It is important that a manager be paid enough to meet overhead and be provided with a reasonable income. As a rough guide, performance fees on assets in excess of $50 million should be deferred as explained above. A firm that has $50 million under management and generates 16% net to investors per annum will generate $3 million in revenue a year. This is sufficient to satisfy overhead for a small firm. By deferring just the performance fees on assets above $50 million, the manager is aligning their interests with those of their investors, and providing investors with a sense of equality. As an added benefit, it allows the manager to compound their own earnings pretax thus increasing their wealth more quickly. The best managers will leap at the chance to do this. As a consequence of this approach, investors will have to pay tax on the deferred returns (a small price to ensure alignment of interests), which will be recouped on redemption. Resistance by a manager to accept deferred compensation is a huge red flag to excessive greed and a lack of confidence by the manager in their own skills.
Peter Urbani is Chief Investment Officer of Infiniti Capital, a Hong-Kong-based hedge fund of funds group.
Ever since the seminal work on Portfolio Theory by Harry Markowitz (1959) and the subsequent work of William Sharpe, the measurement of portfolio returns has been inextricably linked to the level of risk associated with achieving those returns.
This has led to the introduction of a number of risk-adjusted performance measures (RAPMs), most famously the reward-to-variability, or Sharpe Ratio.
Typically calculated as the portfolio returns in excess of those of the risk-free rate over the standard deviation of portfolio returns, the Sharpe Ratio embeds the concept of the variance, standard deviation squared, or volatility as the appropriate measure of ‘risk’ to use. Over time, practitioners and academics alike have realised that this poses a number of problems for the accurate measurement of ‘risk’. In fact, the use of variance was largely an act of convenience to simplify the math in the days before computers. Markowitz himself has said that for some investors semi-variance might be a more appropriate measure to use.
The reason for this is simply that variance, or standard deviation as is more commonly used (the square root of the variance), is not a measure of ‘risk’ at all, but rather a measure of uncertainty. Standard deviation suffers from a number of well known deficiencies, most particularly the fact that it does not differentiate between good (upside) ‘risk’ and bad (downside) ‘risk’. Moreover, it is a symmetric measure that assumes both upside- and downside-variance are the same.
In recognition of these deficiencies, a number of other RAPMs have been developed to better address these issues. Probably the best known of these is the Sortino Ratio which replaces the standard deviation with the downside deviation or second lower partial moment (LPM2) as the denominator in the Sharpe Ratio.
Still others include the modified Sharpe Ratio where the denominator of risk is represented by the Cornish Fisher expanded or ‘modified’ Value at Risk (VaR).
More recently, Shadwick and Keating pioneered the use of the Omega Function, sometimes also used as the Omega Ratio. In this formula, the area under the probability curve in excess of some threshold return is taken over the area under the curve of the downside part of the distribution. This can be calculated in either a discrete form using empirical data, or a continuous form by fitting a distribution.
From a practitioner’s perspective, what we care most about is how well these measures predict the relative ranking from one period to the next and whether or not using one particular method produces superior returns to another. Although these RAPMs are typically used for calculating the relative ranking of funds they can also be, and often are, used as the objective function in direct portfolio optimisations. For instance, maximising the value of your portfolio’s Sharpe Ratio is the same as minimising its variance and gives the same set of weights as the classical Markowitz mean variance optimisation formulation. Minimising your ‘normal’ VaR will give the same solution. However, as mentioned previously, measures based on standard deviation such as Sharpe and the normal VaR calculation do not consider the asymmetry of returns.
In this article, we examine the performance of a new risk-adjusted performance measure called the Single Fund Analysis (SFA) score, developed by Infiniti Capital. This measure is a weighted average of a number of underlying statistics that has also been standardised to a reference data set making it both a relative and conditional measure. The SFA score can further be decomposed into risk, return and persistence sub-scores.
The study referenced below, compares the outof- sample performance of a portfolio built using the SFA score as its objective function versus the performance of portfolios built from the same data set using the Sharpe, Sortino and Omega measures. For reference we also include a naive benchmark made up of an equally weighted continuously rebalanced portfolio of all of the 36 underlying hedge funds in the selection universe. The portfolios are re-optimised to the objective function and rebalanced on a quarterly basis.
The results of the study suggest that the SFA score is capable of generating annualised rates of returns (CAGR) of around 15% versus those of around 11.5% for the Sharpe Ratio, 13% for the Omega Ratio, and just 10% for the Sortino Ratio.
More importantly, although the Sharpe Ratio of the resultant time series remains better for both the Sharpe and Omega portfolios, the ratio of the annualised return to the absolute drawdown over the period, which is arguably a better measure of realised risk to return, remains highest for the SFA score portfolio.
Jaksa Kristo, University of Zagreb, Faculty of Economics and Business, Croatia
The financial crisis has revealed that the financial sector has a single core with strong mutual influences and spill-over effects both domestically and internationally. The importance of ‘looking at the big picture’, instead of focusing only on supervision of single institutions, has been highlighted during the financial crisis, as well as in recovery interventions. New regulatory changes have led to the development of institutions, procedures and committees for macro-prudential supervision, to ensure the future stability of the financial sector.
In previous years, regulators and supervisors were too focused on the micro-prudential supervision of individual financial institutions and did not monitor the macro-systemic risks in the global financial market. It was assumed that if supervisors ensured individual financial institutions were safe, systemic stability would look after itself. Yet, in a recent report, The Fundamental Principles of Financial Regulation, a group of prominent bankers and academics points out that this view ‘sounds like a truism, but, in practice, it represents a fallacy of composition’ (meaning, in trying to make themselves safer in a crisis, financial institutions can behave in a way that collectively undermines the system). It may be prudent, for example, for an individual bank to sell assets when the price of risk increases. However, if many banks and financial institutions do the same, the asset price will collapse, causing financial institutions to take further steps that can lead to a vicious, self-reinforcing downward spiral in asset prices.
Financial stability, before and during the financial crisis, has been ensured through central bank policy and supervisory authorities in charge of micro-prudential supervision. Various supervision models exist in national economies, from prudential and conduct-of-business supervision — integrated in one institution, usually a central bank, or ‘one peak’ — to the ‘twin peaks’ model, meaning the existence of various institutions in charge of the supervision of different financial institutions.
The effectiveness of macro-prudential regulation, emphasised during the financial crisis, is a core assumption behind the new capital proposals and regulatory/supervisory reform in 2009 (espeically in the US Treasury, A New Foundation: Rebuilding Financial Regulation and Supervision, the De Larosière Report in the EU, and The Turner Review in the UK).
Rebuilding financial regulation in the US
In the US, the proposal for a regulatory reform intends to consolidate several federal banking regulators and give the Federal Reserve new power to regulate systemic risk, supplemented with a council of regulators from other agencies. Additionally, there is a proposal to create a consumer financial protection agency to regulate credit cards and mortgages, and the requirement that hedge funds are registered, and the central clearing for many derivatives.
1. promote robust supervision and regulation of financial firms;
The US Treasury’s report, A New Foundation: Rebuilding Financial Regulation and Supervision proposes demanding reforms of the existing authorities, and practices of regulation and supervision, as well as establishing various new authorities and councils. They have proposed the creation of a Financial Services Oversight Council, chaired by the Treasury, which would include the heads of the principal federal financial regulators as members. Its purpose would be to identify emerging systemic risks and improve inter-agency co-operation. The proposal’s hope is that the US would combine comprehensive supervision of financial markets with enhanced regulation of securitisation markets, market transparency, stronger regulation of credit rating agencies and over-the-counter derivatives. The Consumer Financial Protection Agency would be an independent entity dedicated to consumer protection in credit, savings and payments markets. The report also proposed the creation of the National Bank Supervisor, a single agency with separate status in the Treasury, with responsibility for federally-chartered depository institutions. To promote national co-ordination in the insurance sector, an Office of National Insurance within the Treasury would also be created.
Hilary Till, Premia Capital Management, LLC, Chicago; and Research Associate, EDHEC-Risk Institute, Nice (France)
Please note: Due to length, this article will run in two parts over two consecutive issues of Alternative Intelligence Quotient; this is the first section of the article and the second half will run in the upcoming issue.
Crude oil prices increased from $19.84 per barrel at the end of 2001 to the lofty level of $124.08 at the end of July 2008, before plummeting to $44.60 per barrel by the end of 2008. Was this oil-price rally yet another speculative bubble like the late 1990s technology-stock boom; or, more topically, will history see this rally as similar to the bubble in US residential real estate values? Specifically,
We will argue that the answer to this question is a qualified ‘no’, but we acknowledge:
• that many areas of data uncertainty exist in the oil markets, which need to be resolved, given how critical oil is to the global economy; and
In the first section of this article, we will explain how futures traders view the role of price, followed by an examination of data and public statements from the International Energy Agency (IEA) on the state of the oil markets during the summer of 2008. We will then discuss how useful petroleum-complex futures markets are in their price-discovery function: even when fundamental data on the oil markets are sparse or opaque, large-scale supply-and-demand shifts leave footprints in futures-price relationships, from which one can potentially infer the oil market’s fundamentals. In the presence of active futures markets, an observer need not be a member of a cartel or a large corporation to gain insights into the oil market.
We will also discuss how the actions of traders and their algorithmic strategies can impact price, in the shortterm, particularly in a commodity that is exhibiting scarcity.
We will conclude our first section by stating that it would be extremely unfortunate if the oil markets were made even more opaque, which could occur if this became public policy, particularly in the US, to limit oil futures trading (beyond what is needed to prohibit actual or attempted market manipulation).
In our final section, we will explain how an analysis of oil-price drivers is made more complicated by trends in currency values; and that, objectively, one should not exclude this factor in policy debates on what caused the oil-price rally. We will then conclude with a discussion on the debate surrounding oil as a store-of-value.
The role of price and oil supply-and demand data
The role of price
For an oil futures trader, even the premise of this question is perplexing. Instead, a veteran oil futures trader always asks the opposite question: what is the price telling me about fundamentals? The reason for this difference in outlook is simple. The market imposes sufficient discipline to prevent a trader from ignoring price for anything but a very short space of time. We do not expect that commodity futures traders will ever have the benefit of a termlending facility, or become the beneficiaries of other large-scale government bail-outs for unwise (or unlucky) financial participants. Commodity futures traders are instead forced to rely on disciplined risk management, which, ultimately, is based on an in-depth understanding of price and its statistical characteristics.
A futures trader also interprets a commodity’s price as part of a dynamic process. A commodity’s price moves in whatever direction is needed in order to elicit a supply or demand response that will balance a commodity market. It may be useful to review the technical aspects of this interplay.
For a number of commodities, either storage is impossible, prohibitively expensive, or producers decide it is much cheaper to leave the commodity in the ground than store it above ground.
The existence of plentiful, cheap storage can act as a dampener on price volatility since it provides an additional lever with which to balance supply and demand. If there is too much of a commodity relative to demand, it can be stored. In that case, one does not need to rely solely on the adjustment of price to encourage the placement of the commodity. If too little of a commodity is produced, one can draw on storage; price does not need to ration demand.
Now, for commodities with difficult storage situations, price has to do a lot (or all) of the work of equilibrating supply and demand, leading to very volatile spot commodity prices. A defining feature of a number of commodities is the long lead-time between deciding on a production decision and the actual production of the commodity. It is impossible to exactly foresee what demand will be by the time a commodity is produced. This is why supply and demand will frequently not be in balance, leading to large price volatility for some commodities.
In the case of oil, it is prohibitively expensive to store more than several months worth of global consumption. Rowland (1997) explained the situation as follows:
‘From wellheads around the globe to burner tips, the world’s oil stocks tie up enormous amounts of oil and capital. The volume of oil has been estimated at some seven to eight billion barrels of inventory, which is the equivalent of over 100 days of global oil output or two and a half years of production from Saudi Arabia, the world’s largest producer and exporter of crude oil. Even at today’s low interest rates, annual financial carrying costs tied up in holding these stocks amount to… more than the entire net income of the Royal Dutch/Shell Group.’
Written by: Dennis Ryan and Sonia Xavier, Conyers Dill & Pearman, Dubai
Conyers Dill & Pearman advises on the laws of the Cayman Islands, British Virgin Islands, Bermuda and Mauritius, and comprises 600 staff in 11 jurisdictions with more than 150 lawyers. The firm specialises in company and commercial law, commercial litigation and private client matters. Dennis Ryan and Sonia Xavier are associates in the firm’s Dubai office, and specialise in all aspects of corporate finance and the formation of investment entities.
Investment funds domiciled in the Cayman Islands have historically faced challenges when seeking to invest into Indian capital markets. One of the major hurdles in this regard has been addressed by the admission of the Cayman Islands Monetary Authority (CIMA) as an ordinary (ie, full) member of the International Organization of Securities Commissions (IOSCO) on 10 June 2009.
By way of background, the IOSCO Objectives and Principles of Securities Regulation were endorsed by its member regulators of various securities and futures markets in 1998 and, generally, are viewed by securities regulators as the key international benchmarks on sound principles and practices for securities regulation. Currently, IOSCO members regulate the vast majority of the world’s securities markets.
To access the Indian markets, an investment fund must register as a Foreign Institutional Investor (FII) with the Securities and Exchange Board of India (SEBI). In the past, since CIMA was not a member of IOSCO, SEBI often engaged in extensive due diligence and enquiries before allowing registration of a Cayman fund as an FII. As a result, few Cayman Islands funds have registered with SEBI. CIMA’s admission to IOSCO looks set to change this trend in favour of Cayman Islands funds.
The timing could not be better. With emerging markets competing to attract liquidity, the Cayman Islands, with over 9,000 CIMA registered investment funds, a proven track record with investors and an excellent and sophisticated service infrastructure, has a great deal to offer India and investors that wish to access its markets.
One remaining challenge is that the Cayman Islands do not currently have a tax treaty with India. Mauritius, on the other hand, has long been the preferred jurisdiction for investment in India as a consequence of the favourable double taxation agreement between those countries (the Mauritius-India DTAA), contributing to around 44% of foreign direct investment (FDI) into India.
Investment funds from non-tax treaty jurisdictions have developed a structure involving a wholly-owned Mauritius subsidiary for purposes of Indian investment. Typically, this structure requires a Cayman Islands (or other non-treaty jurisdiction) investment fund to register with SEBI as an FII. The Mauritius subsidiary fund will then be registered with SEBI as a sub-account of the FII, permitting it to invest directly in Indian securities, via SEBI.
Written by: Julien Rerolle and Cédric Rimaud, Spread Research, France
Spread Research is an independent credit research company dedicated to providing value-added analysis on the credit worthiness of high-yield corporates. Over the last five years, Spread Research has developed a robust analytical framework to analyse the rating of high-yield debt issuers, publishing both corporate rating indications and investment recommendations for the benefit of the investment community.
Asset management firms, hedge funds and other institutional investors typically receive three kinds of investment advice: first, from the investment banks that are keen to promote their trading and investment banking operations; second, from the rating agencies’ credit ratings, for which the issuers have to pay annual fees, and which are often used in the guidelines of an investment mandate; and third, from their own research analysts, who often rely on the research of the investment banks and the rating agencies, as well as other publicly-available information. This article first reviews the current debate on the independence of each of these players as providers of fundamental research and then presents a short study on the track record of a specific provider of independent credit research, showing that independent credit research can add significant value over time.
A short review of some literature
In their investment process, asset managers rely on external sources to provide them with sufficient information to select the best investment opportunities. In a recent paper (‘Executive Comment: An Examination Of How Investor Needs Are Served By Various Ratings Business Models’, April 2009), Standard & Poor’s (S&P), one of the three main certified rating agencies, classifies these sources along three different business models: the ‘subscriber-fee model’, the ‘government utility model’ and the ‘issuer-fee’ model. The difference is mainly centred on the sources of the funds that finance this research: the investors, the taxpayers, or the corporations issuing public debt, respectively.
A lot of literature has been published on the effect of research on asset prices in the market for publicly-tradable securities. Beaver et al (2006) make the distinction between the purpose of the research between the ‘contracting’ role of certified rating agencies and the ‘valuation’ role of non-certified rating agencies. The ‘issuer-fee’ model takes its purpose in the need for issuers and investors to comply with listing requirements, as they are imposed by market regulators, and investment guidelines for mutual funds; therefore, it is of a ‘contracting’ nature. The ‘subscriber-fee’ model serves the need to perform an independent ‘valuation’ of securities before choosing to buy or sell them. The ‘government utility model’ would stand in between these two groups.
First, let us review the role of the rating agencies. In its July 2008 Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, the Securities and Exchange Commission (SEC) has singled out the problem of the ‘issuer pay’ conflict, and has made several recommendations to ensure that changes are implemented to avoid that rating analysts be part of the fee discussions in the rating analysis. It does not, however, solve the fundamental issue of the independence of the analysis. Their fees are paid by the issuers of the debt instruments they rate; this is the first conflict of interest. Back in 1975, when the SEC created the Nationally Recognised Statistical Rating Organisation (NRSRO) status, ratings were remunerated by investors. Whether we should go back to the old model remains an open question. Those who followed blindly the ratings published by the rating agencies now understand that they must conduct their own research. Not doing so means being late to the game, at best. Some commentators, like Christopher Wright (2009), consider that the competition among credit rating agencies will bring benefits. He identifies three areas where new entrants can come a long way in asserting their competitive advantage: the timeliness of the information they provide, the quality of the research underpinning the credit rating and the management of their potential conflicts of interest.
As early as March 2005 in France, the national regulator, the Autorité des Marchés Financiers (AMF) gave its approval for the creation of an association of independent credit analysts, the Compagnie des Analystes Financiers Indépendents (CAFI), whose goal was to promote the independence of research in the investment industry. But the debate has taken a new dimension, following the recent financial crisis. On 23 April 2009, the European Parliament approved a set of rules on credit ratings, asking rating agencies to stop providing advisery services and disclose their models, among other things. It is clear that the oligopoly of the three main agencies (Fitch, Moody’s and S&P’s), whose work is paid for by the issuers, lends itself to unfair practices that new regulations ought to control. The financial crisis is, in part, a consequence of the improper validation of the credit-worthiness of sub-prime borrowers, repackaged into complex financial transactions and given a false sense of security through a model-implied rating. Discussions are also going on in the US, with the SEC reviewing ideas to regulate them.
Written by: Niall Whelan, ScotiaBank, Toronto and Ranjan Bhaduri, AlphaMetrix Alternative Investment Advisors, Chicago
Niall Whelan is the director of analytics and structured transations at ScotiaBank in Toronto. Ranjan Bhaduri is the managing director and the head of research at AlphaMetrix Alternative Investment Advisors in Chicago.
In a previous paper, Bhaduri and Whelan (2008), we presented a simple model of hedge fund liquidity. That paper explored the fact that not being able to pull one’s money out of an investment instantaneously at a fair price can have a powerful impact on the portfolio. Real world examples include the 1993 Metallgesellschaft debacle (Smithson, 1998) and the recent difficulties experienced by the Bank of Montreal (Perkins and Stewart, 2007), as they attempt to exit from some thinly traded OTC energy derivatives. As we pointed out in our earlier paper, liquidity is a growing issue in the hedge funds arena; increased regulatory pressure has led various hedge funds to extend their lock-up period to avoid more scrutiny. Locking up investments represents a loss of liquidity to the investors and, despite its growing importance, very little quantitative work has been done to understand it in the context of hedge funds. In this article, we explore the impact of liquidity in a simple model.
To address this question in a tractable, heuristic setting we created a model which is intended as an analogy to the liquidity question. It is not difficult to understand that the value of liquidity can also be thought of as an option value, since liquidity gives the holder of a position the right, but not the obligation, to act, which is the classic feature of an option. Whether one chooses to think in terms of liquidity value or option value is largely dictated by context. At the end of this paper, we make the connection between the two interpretations explicit in the context of our specific model.
To recall our model, we consider a hat with b black balls worth -$1 each and w white balls worth $1 each. On each turn, the player chooses whether to draw a ball from the hat and gains $1 if a white ball is drawn, and loses $1 if a black ball is drawn. The selection is done without replacement of balls and the player can elect to stop playing whenever they like. We would like to determine the expected payoff of this game. The role of liquidity is that the player can choose to exit as they please. We showed in Bhaduri and Whelan (2008) that the value of this game exceeds the intrinsic value of the hat itself, which is w – b. Subsequent to that paper, we learned of the seminal work of Shepp (Shepp, 1969) who analysed the same game and attained the same expected payoff. (Interestingly, the motivation related to accounting for biases in ESP experiments arising from preferential stopping.) The work we present here extends from that by considering higher moments and the full distribution of values, as well as relating it to topics in finance.
In this article, we focus on analyses of the payoff and risk-return profiles. We work almost exclusively in the asymptotic limit of large hat size. This is for the three reasons: i) that limit is tractable; ii) it is most meaningful since it relates to long time horizons; and iii) it is indicative of what happens even for small hats, as we showed in Bhaduri and Whelan (2008).
First, we determine the expected value of the game and then introduce the concept of a ‘strategy’ of play. We then determine the standard deviation of the returns from playing, which permits an exploration of the Sharpe Ratio. We then generalise the analysis by deriving the entire distribution of returns by way of the characteristic function. We find highly non-normal value distributions, which argues against use of the Sharpe Ratio. We explore use of the Ω function (Keating and Shadwick, 2002) applied to this problem. We conclude the paper with a brief reinterpetation of the problem as an asset option. This then singles out one of the strategies as corresponding to the risk neutral value.
We start by presenting some numerical results. Each cell in Table 1 represents the expected value of employing an optimal strategy to the corresponding hat. Here, optimal strategy is defined as playing if the expected value is greater than zero, and stopping if the expected value is zero. The table indicates how to effectively play the game and can obviously be extended to larger hats.
Consider the hat with six black balls and four white balls, highlighted in Table 1.
Intuitively, one might think that it is not worth playing since there are more black balls than white balls. However, we observe the counterintuitive result that the expected value is positive (equal to 1/15). Thus, it makes sense to play even with a significant preponderance of black balls. The reason for the positive value is that the right to stop playing at any time overcomes the negative imbalance of black balls to white balls. The player’s advantage of getting to choose to stop picking balls at any time is clearly large. We identify this to be a liquidity/option effect.
Written by: Martina Cassani, Cass Business School, London and Daniel Giamouridis, Athens University of Economics and Business, Athens
Martina Cassani is a student at Cass Business School in London. Daniel Giamouridis is at the Department of Accounting and Finance in the Athens University of Economics and Business, Athens, Greece. He is also Senior Visiting Fellow at Cass Business School, City University, London, and Research Associate at EDHEC Risk and Asset Management Research Centre, EDHEC Business School, Nice, France.
In the last couple of decades, we have witnessed a growing interest in hedge funds. Assets invested in the hedge fund industry have been increasing at a steady pace from about $40 billion in 1990 to just over $1.4 trillion in the second quarter of 2009 (with a peak of about $1.9 trillion in the second quarter of 2008)1. While there have been cases of hedge funds delivering substantial profits to investors, recent studies (see Weidenmueller and Verbeek, 2009) indicate that the portion of these profits that can be attributed to ‘skill’ has — on average — deteriorated over the years. This observation suggests that hedge fund performance in recent years has been dominated by compensations for bearing certain risks, ie, ‘betas’ rather than ‘skill’ or ‘alpha’. Moreover, the hedge fund industry’s poor records on liquidity and transparency, as well as the sky-high fees, have been adding to the ongoing scepticism of investors with respect to the benefits of hedge fund investing. This has given rise to the question of what could be a good-value investment vehicle for one wishing to gain exposure to this asset class.
For about a decade, academics and practitioners have looked at replication strategies as a good-value investment in the hedge fund space. These are investment strategies that aim to produce the investment returns of the broad hedge fund industry, without having to invest in the funds themselves. The resulting portfolios are usually termed ‘hedge fund clones’ and are dynamically managed portfolios of liquid assets. While there are already products — ‘plain vanilla’, as well as derivatives — that can be traded with major investment banks and asset management companies, hedge fund replication professionals report rising interest across institutional investors and forecast a substantial increase in business. In this article, we will review the motivation behind hedge fund clones, discuss the benefits and criticisms that have been put forward, present the current status of the hedge fund clones business, and investigate the performance of selected plain vanilla products.
Motivation, recent research, benefits and scepticisms
The motivation for seeking hedge fund exposure through hedge fund clones is two-fold. On the one hand, investing in individual funds is generally associated with high costs, moderate to low liquidity, lack of transparency, and barriers to entry. A recent article in the Financial Times2 quoted that ‘…clients need transparency and liquidity, they do not like lock-ups or want high fees’. These are perhaps the most critical advantages of hedge fund clones.
On the other hand, the evidence has been increasing that the ‘alpha’ of the average hedge fund or fund of funds manager is very poor and not persistent (for example, see Agarwal and Naik, 2000, and Fung, et al, 2006), and that a large fraction of broad-based performance of hedge funds is due to risk premia (for example, see Hasanhodzic and Lo, 2007, and Giamouridis and Paterlini, 2009).
Collectively, these observations motivate the development of non-discretionary, rule-based investment strategies that utilise liquid assets such as futures, total return swaps, ETFs, and other instruments to replicate the broad-based performance of hedge funds. The structure of these strategies (ie, rule-based) allows minimal charges of about 50 to 100 bps per year as it currently stands. Investors are aware of the eligible list of market underlyings (ie, the possible investments), therefore, the strategies are fully transparent. And the liquidity of the replicating portfolio can be as high as daily, given the liquidity of the traded underlyings.
Recent research has proposed two approaches for the construction of the replicating portfolio: moment matching (for example, see Kat and Palaro, 2005a,b) and factor-based replication (for example, see Hasanhodzic and Lo, 2007). The former seeks to match the moments of the return distribution of the target and the replicating portfolio. The latter is based on a portfolio of assets whose weights are computed with the objective that the tracking error, with respect to replicated portfolio, is minimal. A third approach is based on the implementation of a generic version of a given strategy, which, however, may not be that different from a typical hedge fund (for example, see Mitchell and Pulvino, 2001). A recent paper by Tancar and Viebig (2008) provides a comprehensive overview of the methodologies that have, thus far, been presented in the literature. More recent works propose refinements to the above ideas. Amenc, et al (2009), for example, propose non-linear and conditional hedge fund replication models. Giamouridis and Paterlini (2009) propose modifications to the portfolio construction problem for more stable performance.
While consensus is gathering pace for the benefits of hedge fund clone investing, it is important that some challenges are also acknowledged. Amenc and Schroder (2008) and Tancar and Viebig (2008) provide a discussion of the scepticisms over hedge fund clones. Perhaps the most obvious is that hedge fund clones focus on average performance and the technologies used will not be able to replicate ‘star’ managers. One other challenge is the fact that clones are, typically, based on liquid, exchange-traded or ‘plain vanilla’ derivative instruments and, therefore, they may not be able to replicate the entire risk/return spectrum of mangers trading, in many instances, complex derivatives, and they will only produce a truncated version of a hedge fund. Another argument claims that hedge fund managers are flexible, and are able to switch positions in a very opportunistic manner. Clones, which are based on historical data, will not be able to adapt accordingly.
William Yonge is a partner in Proskauer Rose LLP’s London office where he specialises in issues of financial services regulation and advises on the structuring, establishment and marketing of a range of investment vehicles including hedge funds, private equity funds, funds of funds, UCITS and UK authorised funds.
The current liquidity crisis, in its initial manifestation also known as the ‘Credit Crunch’, is often regarded as a wholly exceptional, even a once-in-a generation event. While the intensity and duration of the current crisis does make it remarkable, the fact is liquidity crises occur more regularly than widely assumed. Previous UK liquidity crises include the Secondary Banks Crisis (early 1970s), the Small Banks Crisis (early 1990s) and the failure of Barings Bank (1995). Non-UK liquidity crises include the collapse of Drexel Burnham Lambert (1990), the Asian Crisis and Yamaichi (1997), the Russian Crisis (1998), Long Term Capital Management Crisis (1998) and the Argentine Crisis (2001).
Notwithstanding this history of liquidity crises, regulators and supervisors, in their prosecution of prudential regulation in recent years, concentrated their efforts on implementation of the Basel II capital adequacy requirement, first published in June 2004. Lord Turner, Chairman of the UK Financial Services Authority (FSA), acknowledges this was mistaken, since it followed that insufficient attention was paid both to growing risks in trading books and liquidity risks which proved fundamental to the crisis. In Lord Turner’s view, ‘This failure to spot emerging issues was rooted in the paucity of macro-prudential, systemic- and system-wide analysis’.
The FSA itself is currently fighting a turf battle of its own in order to preserve its role as supervisor of banks in the UK, with the Bank of England enthusiastic to take that role back. Since before the FSA’s creation, the Bank of England has been responsible for guarding against systemic risk, and there is high level debate as to whether the status quo should continue or whether the FSA should have a joint role alongside the Bank in monitoring and dealing with systemic risk.
The regulators and supervisors must shoulder their share of the blame for the crisis alongside the banking sector. Regulators, led by the FSA in particular, are broadly contrite and understand the need for thoughtful and robust change in their approach to regulation and systemic risk in order to avert, or at least mitigate, the next potential liquidity crisis. It is not yet clear whether the banks will move as quickly to put their own houses in order.
Liquidity risk and regulation — a cause of the crisis
In October 2008, the Chancellor of the Exchequer asked Lord Turner to review the causes of the financial crisis, and to make recommendations on the changes and the regulatory and supervisory approach needed to create a more robust banking system for the future. In March 2009, Lord Turner published his review. In considering the causes of the crisis, under the characteristically frank and transparent title, ‘What went wrong?’, Lord Turner identifies and describes the spectrum of causes, one of which was liquidity risk and regulation in the context of the growth of ‘shadow banking’.
Nathan Hall and Paul Valente are UK-based tax specialists and are part of KPMG’s Global Investment Management and Funds practice.
As the European Union (EU) hedge fund industry has grown, the favourite model has been to manage a Cayman fund from the United Kingdom (UK). This traditional model is now coming under pressure from significant regulatory and tax change.
UK managers are frustrated at the 50% tax change, but the proposal for a Directive on Alternative Investment Fund Managers (the AIFM Directive, or the Directive)1 does not make the decision to move to Geneva a straightforward one.
In this article, we consider the effect that the Directive could have on the location of managers and hedge funds. We also look at recent UK tax changes in this context, and explain how regulation and tax are pushing managers in different directions: the Directive favours EU jurisdictions; UK tax changes are causing managers to look outside of the UK.
Overview of the AIFM Directive
At the beginning of 2008, the global hedge fund industry was managing assets in the region of US $2.7 trillion on the back of a period of tremendous growth. However, 2008 saw the industry shrink, with losses and redemptions pushing down global assets under management to $1.8 trillion2 by the end of the year. In what was primarily a banking crisis, the hedge fund industry found itself, and activities such as short selling, under the spotlight.
Shortly after the April 2009 G20 summit in London, the European Commission released its proposed AIFM Directive. This Directive proposes direct regulation and supervision on the alternative investment fund management sector. It applies to all managers of funds that are not UCITS (ie, not governed by the ‘Undertakings for Collective Investment in Transferable Securities’ Directive)3. As well as hedge fund managers, it also includes managers of private equity funds, commodity funds, real estate funds, infrastructure funds and other alternative funds.
The Directive is expected to take effect in July 2011, assuming that political agreement is reached this year. Its objectives are to:
These are laudable aims, but it is the Directive’s approach that is causing concern; it is unsympathetic to how managers may conduct business.
The Directive regulates fund managers directly, instead of regulating funds. The proposals apply to all fund managers domiciled in the EU managing more than €100 million, unless the funds managed have no leverage and a lock-in period of five years or more, in which case the threshold increases to €500 million. Fund managers will be required to be authorised and regulated in their home state (as is the case already for fund managers based in the UK) and will be subject to initial and ongoing minimum capital adequacy requirements. The minimum capital for the fund manager will be €125,000, but this will increase if assets under management exceed €250 million. Managers compliant with the AIFM Directive will be obliged to follow regulations and provide information on the identity and characteristics of funds managed, internal arrangements on risk management, and the valuation and safe-keeping of assets. Specifically, the proposals put forward disclosure requirements when leverage exceeds the value of equity, and there will be a requirement to use EU-based credit institutions as depositaries.
Conyers Dill & Pearman advises on the laws of the Cayman Islands, British Virgin Islands, Bermuda and Mauritius, and comprises over 550 staff in 11 jurisdictions with more than 150 lawyers. Alex Potts is a litigation associate in the firm's Bermuda office, and has a wide-ranging commercial litigation and arbitration practice, with particular experience of banking, funds and financial services disputes, as well as insurance and reinsurance disputes.
Can a hedge fund make redemption payments ‘in kind’ by way of the issue of ‘participation interests’ in its own illiquid assets, and what is the status of a redeeming investor who has not received any payment at all?
Hedge funds incorporated in Bermuda, the Cayman Islands and the British Virgin Islands have faced substantial legal challenges in 2008 and 2009, especially in meeting liquidity needs for redeeming investors. These challenges are far from over.
Many hedge fund assets and investments have declined both in value and in liquidity. Some assets are hard to value. Other investments are illiquid. Many investors have been seeking to withdraw their investments in hedge funds and to have their shares redeemed for value. It is unlikely, however, that there will be enough cash or liquid assets available to pay all of them, at the same time.
How can a hedge fund deal with a rush of redemption requests?
There are a variety of defensive strategies potentially available to hedge funds holding illiquid assets when faced with a rush of redemption requests and requests for payment. Such strategies might include:
The availability or suitability of any of these strategies will depend on the terms of each hedge fund’s constitutional documents, and the facts and commercial considerations of each particular case.
GFIA has been researching Asian and emerging market hedged and absolute return funds since 1998. Based in Singapore, GFIA’s sole activity is the research of skill-based managers (those seeking alpha from public markets), and it sells this research through advisory contracts and discretionary money management of its Wittenham funds of funds and managed accounts. The firm is fully independent.
Emerging market equity investing has typically been characterised by dramatic price movements through market cycles in both directions. In addition, the inefficient, diverse and often rapidly developing nature of emerging capital markets creates challenges which can create unexpected risks for non-specialist investors.
In this article, GFIA analyses and discusses how hedge funds specialising in emerging market investing can both exploit these market inefficiencies and protect themselves from extremes of price movements, thereby generating stronger risk-adjusted returns over time. The article further evaluates the performance of emerging markets hedge funds against the traditional investment methods, including long-only funds, using various metrics. The key conclusions of the study are:
This survey explores the structure of the cost base for small- to medium-sized hedge fund managers in the current market, looks at managers’ appetite for outsourcing and also where costs are expected to change in future.
Twenty hedge fund managers took part in the survey, which included hour-long interviews and the completion of a questionnaire.
Costs are often categorised in different manners, which poses challenges in obtaining a meaningful comparison of costs. Therefore, an interview approach was adopted to conduct this survey, supported by a structured questionnaire. This allowed KPMG to probe behind the figures, ensure ‘like for like’ comparisons were obtained and explore emerging trends. This survey was sponsored by PCE Investors Limited (PCE), who provide a range of business support services to hedge funds of varying size. PCE can perform operations, risk management, marketing, compliance and an IT infrastructure, as well as providing physical amenities if necessary. They can also provide independent FSA fund vehicles under the PCE regulatory umbrella. PCE currently have clients with c. US$1.5 billion under management.
Investors exert an increasing influence on costs and, in particular, their desire for improved governance standards and compliance. Where over 70% of a manager’s clients are institutional investors, the proportion spent on corporate control increases significantly. Eight out of 10 of those polled consider that investors are placing more emphasis on the back- and middle-office.
Half of managers are taking steps to reduce costs either in premises, staff or front-office systems.
The degree of outsourcing is high and the appetite for and extent of outsourcing is increasing; 30% of managers are looking to outsource additional services.
Segregation of duties continues to be a challenge within small- and medium-sized funds; only 6% of respondents performed risk management by someone independent of the front office.
Most managers state they are carefully monitoring and controlling costs. In this report, costs excludes front office salaries and bonuses since these contain a high discretionary element which otherwise would not allow a meaningful comparison between firms.
Keith Robinson is a partner in the financial services group of Dechert LLP, resident in the firm’s Hong Kong office, and is the head of the firm's Asian financial services practice. Derek Newman is a senior associate in the financial services group of Dechert LLP, resident in the firm’s Hong Kong office.
As the current financial crisis continues to unfold, the global alternative investments industry has resigned itself to the fact that increased regulation is inevitable. As recently stated by Andrew Baker, chief executive of the Alternative Investment Management Association, ‘we know which way the wind is blowing’. Recently, the US Congress has taken its first steps in making the anticipated regulation a reality, proposing legislation that could have far-reaching implications for alternative investments.
At the end of January 2009, the ‘Hedge Fund Transparency Act of 2009’ (the Hedge Fund Bill) was introduced into the US Senate. The Hedge Fund Bill would effectively eliminate the Section 3(c)(1) and 3(c)(7) exceptions of the Investment Company Act of 1940 (the Investment Company Act) on which many alternative investment funds (both US and non-US) currently rely to avoid US registration under the Investment Company Act. If the Hedge Fund Bill is passed by the US Congress, alternative investment funds with US$50 million or more in assets will be required to register with the US Securities and Exchange Commission (SEC). Shortly before the introduction of the Hedge Fund Bill, separate legislation was introduced in the US House of Representatives entitled the ‘Hedge Fund Adviser Registration Act of 2009’ (the Advisers Bill). The Advisers Bill would eliminate the ‘private adviser exemption’, which is used by many alternative investment fund managers to avoid registration with the SEC.
The scope of the proposed legislation, as currently drafted, is potentially very far-reaching. For instance, the scope of each Bill is much broader than ‘hedge funds’, and may impact the operations of private equity funds, venture capital funds, structured products and other privately-offered funds. In addition to the above, there have been recent calls to substantively regulate hedge fund operations, and there are pending initiatives at the US federal and state levels to revise tax laws and regulations, so as to permit the taxation of carried interest or performance fee income of hedge and private equity fund managers at a significantly higher rate.
This article provides an overview of the Hedge Fund Bill and Advisers Bill, and attempts to highlight areas of uncertainty with respect to the application of the new requirements, including their application to non-US funds and non-US managers. In addition, we briefly discuss the calls for substantive regulation of hedge fund operations and the proposed adverse changes to the taxation of carried interest. We conclude with suggested steps an investment adviser may wish to take to prepare for impending regulations and a new market focus on compliance controls and transparency.
The Hedge Fund Bill
Currently, most hedge funds, private equity funds, venture capital funds and other private investment vehicles (collectively, we will refer to them as private funds) rely on the exceptions from the definition of ‘investment company’ provided by Section 3(c)(1) and 3(c)(7) (commonly referred to as the ‘100 person exception’ and the ‘qualified purchaser exception’, respectively). These exceptions effectively remove a private fund from most provisions of the Investment Company Act. The Hedge Fund Bill proposes to eliminate these exceptions and, instead, convert them into conditional exemptions under new Section 6(a)(6) and 6(a)(7), which correspond to current Section 3(c)(1) and 3(c)(7), respectively. Under these new provisions, private funds would continue to be exempt from most substantive provisions of the Investment Company Act. Although this appears to be a technical change, the implications of this change may be far-reaching, as private funds seeking to rely on the new exemptions must:
• in the case of certain private funds with ‘assets or assets under management’ of US$50 million or more (large private funds), register as investment companies with the SEC and disclose specified information;1 and
In addition to registering with the SEC, large private funds would be required to: (i) maintain certain books and records; (ii) co-operate with SEC requests for information or examination; (iii) disclose to the SEC various information, such as the large private fund’s primary accountant, prime broker, ownership structure, affiliation with other financial institutions, minimum investment commitment, total number of investors and current asset value. While the current language of the Hedge Fund Bill also requires the disclosure of the name and addresses of its investors (including natural persons), industry lawyers and other professionals were quick to point out that this disclosure requirement is at odds with most privacy requirements. Its sponsors have subsequently clarified that the Hedge Fund Bill is not intended to require disclosure of the identity of large private fund’s investors but, rather intends disclosure regarding the managers that collect fees from the large private fund.
Curtis, Mallet-Prevost, Colt & Mosle LLP is an international law firm headquartered in New York, with branch offices in the United States, Mexico, Europe and the Middle East. Founded in 1830, Curtis has a diversified practice and range of experience which permits our lawyers to offer global representation in the most challenging assignments.
Managers of funds of funds, institutional investors and family offices have long sought to invest their assets with professional money managers, with the expectation that the investment advice provided by these professionals will lead to greater returns. In the wake of Bernard Madoff’s arrest, and the allegations against him of perpetrating a massive criminal securities fraud and similar allegations against other managers, these investors should now put greater thought into the means with which they invest with professional managers and the degree of control afforded to those managers. This article will provide guidance with respect to the relative benefits and risks associated with investments in unregistered collective investment vehicles, particularly hedge funds, versus the retention of third-party managers who have discretionary investment authority over managed accounts.
Investments in hedge funds
In recent decades, investors have increasingly directed a substantial amount of their investments to hedge funds. Generally, a hedge fund is a private investment vehicle that pools capital from a number of investors and invests the pool’s aggregate assets in securities and other tradable instruments, often using leverage to take positions that are larger than would be otherwise available. Hedge funds generally operate under exemptions from registration available under the Investment Company Act of 1940, as amended. Therefore, investment companies (ie, mutual funds). Hedge funds employ one or more of a wide variety of investment strategies and often utilise a sophisticated hedging of their positions to minimise investment risks and provide superior returns to their investors.
Positive attributes of hedge funds
Experience: most fund managers have the investment experience and industry know-how necessary to allocate resources and assume risk in a manner that maximies profit. This experience is often a significant factor in the manager's ability to draw new investors to the fund.
Economies of scale: hedge funds, as collective investment vehicles, are able to take advantage of economies of scale by using large pools of capital to take long positions, and hedging positions that are significant from a size and/or risk perspective.
Cost efficiciences: unlike solitary investors, hedge funds are often able to negotiate better brokerage and clearing rates, due to their high volume of trading.
Investment opportunities: the availability of a large pool of capital offers hedge funds the ability to participate in investments with high minimum investment requirements and to have proprietary access to certain investment opportunities and information.
Negative attributes of hedge funds
Lack of transparency: investors in hedge funds are often unaware of the securities held by the fund, and such investors may, in fact, be restricted from accessing or disclosing such information. Periodic hedge fund reporting is often limited to monthly or quarterly reporting of the fund’s net asset value (NAV) and the value of the investor’s capital account or share-holding.