The quarter past: Editorial Analysis of Recent Market Developments
- Lipper Hedgeworld.com staff, Chicago.
The fourth quarter of 2006 saw the latest trend in the ever-rolling democratisation of hedge funds: cloning them.
Whether the new methodology will represent just a series of academic advancements in research, or a revolution in hedge fund investing, remains to be determined. The idea is to satisfy the needs of pension plans, which require more and more transparency and liquidity from their managers while expecting to pay less in fees. But replicating hedge fund strategies at a lower cost is really what may be the most promising way to align returns with costs, some academics say. With hedge fund returns produced synthetically, advocates of cloning techniques argue that one can avoid the usual drawbacks surrounding hedge fund investments, including the need for expensive and time-consuming due diligence, illiquidity, lack of capacity, poor transparency as well as style drift issues, and all of that without the high management fees.
It is a simple but memorable message: Sack your fund of hedge funds manager and boost returns. Professor Harry Kat of the Cass Business School at the City of London University believes the idea is compelling and has invented a system to make it a reality. With PhD student, Helder Palaro, Mr. Kat has launched FundCreator, located at www.fundcreator.com, a risk control system that allows investors to design futures trading strategies, which the inventors dub synthetic funds. These funds use 78 futures contracts to replicate different risk-return profiles, offering an alternative to funds of funds. ‘People want to take the cost of their hedge funds down,’ Mr. Kat said in an interview. ‘They realise if they didn't pay 3% plus 30%, they would do better than the 6%–7% average returns that Hedge Fund Research is showing (for funds of funds).’
Goldman Sachs developed a replication tool for roll-out in early 2007, targeting high net worth investors and institutions unable to invest in conventional hedge funds. The Absolute Return Tracker Index, or ART, would be based on a product basket comprising fixed-income, equities, credits, commodities and volatility indexes. The fund will only consider including the most liquid, representative and tradable indexes in each of the five categories. The emphasis on liquidity means that there will be daily trading and, thus, no investor lock-up. One thing ART won’t do is invest in hedge funds. Instead, the aim is to offer a complementary strategy for investors who can't invest in hedge funds to get that performance by others means.
Middle East developments
Kuwaiti asset manager, Global Investment House, in October announced the launch of its new GCC Islamic Index, which will track the performance of Shari’a-compliant companies in Gulf Co-operation Council companies. Omar El-Quqa, executive vice president at Global, said the index ‘establishes itself as the benchmark for Shari’a-compliant investment in GCC countries, introducing the immense Shari’a-compliant investment opportunities available in our regional market.’ The index is composed of the 66 largest Shari’a-compliant companies, and is 100% market cap weighted in accordance with International Finance Corporation formulae. Total market capitalisation added up to around US$141.8 billion as of the close of trading on 1 October.
2006 Alternative Investment Survey
John Dyment, Jon Olstein and Annalisa Jones, Deutsche Bank Hedge Capital Group, New York.
Deutsche Bank’s 2006 Alternative Investment Survey tracks the opinions of almost 700 invetor firms, representing more than $900 billion in assets invested in hedge funds. It is the largest survey of investor sentiment in the hedge fund industry.
Introduction
Last fall, we conducted our 2006 Deutsche Bank Alternative Investment Survey. More than 1,000 investors from almost 700 firms responded, telling us their opinion on trends in the hedge fund industry, what startegies will perform best in 2007, and where they will put their money in 2007. The assets managed by these investors corresponded to almost two-thirds of the hedge fund industry.
In additon to our on-line survey, we conducted interviews with more than 200 institutions across the globe. We asked them how their firms were responding to challenges in the hedge fund industry and which trends they wanted to understand better. These interviews helped shape the survey’s conclusions and give colour to the opinions of the respondents.
Investor characteristics
Investor categories
The investors we surveyed represent banks, corporations, insurance companies, consultants, family offices, high net worth individuals, wealth management companies, funds of funds, pensions, government organisations, endowments and foundations. Throughout this report, we group the responses of similar investors in categories. Banks, corporations and insurance companies comprised 13% of respondents. 6% of respondents were consultants. Funds of funds were 47% and family offices, high net worth individuals and wealth management companies totalled 17%. Another 17% were pensions, endowments, government organisations and foundations.
Investor regions
Investors from more than 30 countries responded to the survey, including 36% from Europe, the Middle East and Africa (referred to as Europe in this report); 8% from Asia and Australia (referred to as Asia in this report); and 56% from North and South America (referred to as the Americas in this report).
Direct hedge fund investments
About 90% of respondents reported that they make direct hedge fund investments. Almost a third of those investors who do not make direct investments indicated that they invest in funds of funds. Only those investors who make direct investments were asked to give their opinions on hedge fund industry trends and strategies.
Assets
Survey respondents told us they had more than $900 billion invested directly in hedge funds, which represents two-thirds of the $1.4 trillion invested in the industry. They report total assets under management of more than $3.8 trillion in all investment types (stocks, bonds, hedge funds, private equity investments and real estate). Almost half of the investors responding had over $1 billion under management.
Number and size of hedge fund investments
In 2006, most investors reduced the number of new allocations they made to hedge funds compared to previous years. The median number of new allocations for 2006 was just 10, which is a reduction from 2005 when the median was 13. Pensions, government organisations, endowments and foundations, were essentially unchanged from 2005 levels.
Investment Smorgasboard
Hemal Naran, HSBC Actuaries and Consultants Ltd.,UK.
There has been much debate in the press as to why UK institutional investors have been slow to consider the full menu of investable assets that many of their European and American counterparts have successfully utilised. The face of the UK pension scheme has remained stagnant with regard to its asset allocation, with too much exposure to only one slice of the economic pie for inflation beating returns, predominantly domestic equities. The author believes that trustees should consider a more diversified investment approach. This is a concept that HSBC have called ‘Diversified Growth’.
The UK pension system, once the envy of much of the world, is now in well documented crisis. Pension scheme sponsors are trying their hardest to manage the cost of their pension schemes, which have risen in the face of tax and regulation, volatile equity markets, lower interest rates and increased longevity.
Despite all their pension woes, most UK pension schemes continue to invest in a staple diet of equities, predominantly domestic, with some bonds and maybe property for diversification. This asset mix has not changed considerably over the last 20 to 30 years.
Historically, UK schemes invested predominantly in domestic equities to provide inflation beating returns in order to meet the long-term cost of retirement benefits. Over time, the diversification benefits of investing in overseas equities, as well as the abolition of exchange controls in the UK, resulted in pension schemes increasing their exposure to overseas markets, although to a limited extent. However, in recent years, increasing globalisation has resulted in many capital markets performing in tandem, thereby not providing the diversification benefits that one had hoped for.
Until recently, trustees still expected strong equity returns to meet their schemes’ liabilities. Exceptional returns from equity markets in the 1980s and 1990s had lulled the pensions industry into a false sense of security ? trustees seemed unconcerned that expected returns might not continue, or that liabilities might rise more than predicted.
In reality, equity returns have clearly not lived up to expectations, as seen during the 2000 to 2003 bear market. Additionally, the removal of tax relief on income from dividends in the UK has also been very harmful to pension schemes and the case for equity investment.
Canadian Hedge Fund Market Poised for Growth
Erwin Stuart and Alex Chapman, Mintz Fund Services,Toronto.
Hockey aside, Canada seldom appears on the US radar. As late as 2001, a Canadian official in Washington was surprised to learn that the newly-minted Vice President, Dick Cheney, was not familiar with Canada’s tar sands. ‘We have more oil than any country on earth, except Saudi Arabia,’ he told Mr. Cheney. Left unsaid was that Canada is a tad closer to the US.
Like our oil sands, Canada's hedge fund industry has flown under the radar for years. We expect that will soon change.
Roughly US$33 billion is under management in Canadian hedge funds today — a 10-fold increase over the 2000 figure. Traditionally, a ratio of 10-to-1 is used to compare the size of US and Canadian markets; given the enormous size of the US market it would seem that the growth is scheduled to continue.
While the Canadian market is not crowded, some larger domestic pension funds are making serious investments in hedge funds. With roughly US$80 billion in assets, the Ontario Teachers’ Pension Fund will quadruple its current investment in hedge funds to about US$16 billion. With leadership like this, you can expect other institutional investors to follow.
At the other end of the spectrum, more Canadians are able to invest in hedge funds than their US counterparts. To be accredited, a Canadian requires C$200,000 in income or C$1 million in assets — well below the US thresholds. The accredited investor rule also does not need to be applied for a potential hedge fund investor if the investment is C$150,000 or greater. This is in contrast to the US, where recently proposed rules have defined an accredited investor as having US$2.5 million in investment assets in addition to the present requirements of US$1 million in net worth or annual income of US$200,000.
The Canadian economy is resource heavy. Apart from tremendous oil-sands investment in the past decade, domestic and overseas mining operations also raise capital on the principal exchanges — the Toronto Stock Exchange (TSX) for senior equities and the TSX Venture Exchange. Both are modern, electronic trading facilities with world-class technology. In a July 2005 article published in The Globe and Mail, Miklos Nagy, Chairman of Canadian Hedge Watch Inc., was quoted as saying that between 10% and 25% of the average daily volume on the TSX are hedge fund trades.
Blowups: A Year to Remember
Emma Trincal, Lipper HedgeWorld.com, New York.
Looking back on the hedge fund blowups of 2006, many of the failures were brought on by bad bets on energy and commodities, illustrated by history’s biggest hedge fund collapse.
This year saw the biggest hedge fund collapse in history with the demise of Amaranth Advisors, which lost more than US$6 billion in a matter of weeks. While last year’s spectacular hedge fund defaults were mostly related to fraud, this year, strategies or trades going wrong were the main villains. The industry has been hurt by a series of bad bets in 2006, particularly in the energy sector, which caused financial loss among investors. Last year, investors were mostly cheated.
From a dollar standpoint, investors may have been better off in 2005 with the deceptions. The wrong trades of a few traders this year have ended up costing more than the dishonesty of a handful of managers the year before. In the fall, Amaranth Advisors lost US$6 billion. That loss, in itself, represented much more than the roughly US$1 billion that vanished last year due to the combined frauds that went on at Bayou Management, Philadelphia Alternative Asset Management, KL Group and a few others. From a moral standpoint though, it’s probably easier for an investor to lose on the market than to be the victim of a scam. People will remember Bayou for what it was: a fraud. People may remember more insightful lessons from Amaranth and notice that after all, the market survived the storm.
‘The biggest story of the year is clearly Amaranth,’ says John Brunjes, a Hartford, CT- based lawyer with McCarter & English. With this blowup, Brian Hunter, a 32-year-old energy trader operating from Calgary, Canada, forced the giant Connecticut-based fund to shut down in just a few weeks. The multi-strategy fund had taken a greater-thanreasonable exposure to the energy market, while Mr. Hunter was making directional bets on the spread between the price of winter and summer gas. ‘It’s the big story because it was the largest gross loss in value in the shortest period of time,’ says Mr. Brunjes.
But strangely, ‘Amaranth was also the story that wasn’t,’ he adds. ‘The market absorbed the magnitude of the loss without much of a blip.’
Another characteristic of the year is that many failures took place in the energy and commodity space. Prior to Amaranth, a couple of blowups revealed early red flags.
In the summer, MotherRock, an energy-trading hedge fund created by former Nymex President, J. Robert ‘Bo’ Collins, began to implode after a couple of consecutive monthly losses. Offering similarities with Amaranth, which later would buy its energy book, MotherRock did very well earlier in the year, but was suddenly hit by the volatile natural gas market. Markets and losses spared no one, not even some of the most sophisticated market wizards. Dwight Anderson, the former head of commodities investing at Tiger Management and a commodities portfolio manager at Tudor Investments, who created Ospraie Management, a fund in which Lehman Brothers bought a 20% stake last year, faced an 18% drawdown last spring for one of his funds. The US$250 million Ospraie Point fund, a more concentrated version of the firm’s main commodities fund, lost money due to a series of bearish bets on copper while commodities prices were surging. Press reports announced that Ospraie was shutting down. In reality, Ospraie avoided the disaster by winding down the Ospraie Point fund and moving investors' capital into the main fund.