The Hedge Fund of Tomorrow: Building an Enduring Firm
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BNY Mellon and Casey Quirk & Associates
This is the third collaboration between BNY Mellon and Casey Quirk & Associates, marking the latest instalment in a series started in 2004 with ‘Institutional Demand for Hedge Funds: New Opportunities and New Standards’, and expanded in 2006 with ‘Institutional Demand for Hedge Funds II: The Global Perspective’. In our first two papers, we outlined how institutional investors would become a key source of capital for hedge funds, leading to profound changes in the industry.
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 (Issue #35).
The state of the industry
Summary
During the past decade, hedge funds represented one of the fastest growing segments in asset management, with industry assets under management expanding at more than 20% per year between 2000 and mid-2008. These years of rapid expansion were marked by a shift in both hedge funds’ investor base and in several core investment attributes, while some of the industry’s more controversial traits, including its obsession with secrecy and an antagonistic attitude towards any regulation, calcified into business as usual.
Since peaking in 2008, hedge funds experienced a severe contraction, with total assets under management falling by half by mid-2009. High-net-worth investors, primarily from European and Asian platforms, led the redemption charge. Certain institutional segments, however, saw meaningful outflows — in excess of 20% in the case of Japanese institutions. The result is not only a smaller industry, but a capital base that is more institutional and more North American. Remaining investors across the board are broadly committed to hedge funds, but need to be convinced that the industry will correct the business model imbalances and the flaws exposed by the recent crisis.
Hedge funds’ evolution since 2000
There have been three distinct phases to the hedge fund industry’s rise and recent fall: their coronation as ‘bear market heroes’ during 2000-2002, their expansion through the asset-growth wave of 2003-2007 and their contraction from crisis and redemptions during 2008-2009.
During the ‘bear market heroes’ phase, hedge funds comprised a relatively small and peripheral industry, characterised by small funds; a selective and savvy investor base of ultra-high-net-worth groups and a few large, innovative institutions; and investment strategies that promised to be both liquid and uncorrelated to the equity markets. In this first phase, the stable returns hedge funds provided investors during the equity bear market of 2000 to 2002 (without the illiquidity costs other alternatives imposed) awarded the industry powerful credibility and acted as a beacon to a wide swath of new investors, both individual and institutional.
During the industry’s second phase of evolution, between 2003 and 2007, four major trends further shaped the growth of hedge funds:
Source: HFR eVestment Alliance, and BNY Mellon & Casey Quirk Associates
Mainstream investors enter
Institutions in ever-growing numbers began using hedge funds as a source of diversification and more stable, ‘absolute’ returns. Sustained low interest rates and flattening equity returns, coupled with institutions’ required rates of return, helped stoke this interest. Our 2004 report indicated that US institutions had $66 billion invested in hedge funds in 2003, or roughly 8% of total hedge fund assets under management. By year-end 2007, that figure mushroomed to US$290 billion, approaching 16% of total hedge fund assets. Globally, institutional investment in hedge funds rose from US$361 billion as of year-end 2005 to US$748 billion just two years later.
High-net-worth individuals also flocked, as wealth advisers and bank platforms subscribed to the same investment premise institutions found so attractive. In particular, a combination of stable returns with high levels of liquidity made hedge funds ideal engines to power the structured notes favoured by many European and Asian investors.
Growing beta, leverage and illiquidity
Asset growth and shifts in the capital markets environment changed the mix of hedge fund strategies, with growth occurring in equity-oriented strategies (primarily long-biased, long-short equity), multi strategy and event-driven, at the expense of the ‘classic’ hedge fund strategies that dominated prior years. Higher correlation of returns to equity markets, less dispersion among hedge fund managers, growing use of leverage and creeping portfolio illiquidity accompanied these changes. In addition, funds of hedge funds’ liquidity terms failed to evolve with the liquidity of underlying hedge fund investments. In short, key features that attracted new investors to hedge funds during the bear market began to fade.
The Oil Markets: Let the Data Speak for Itself, Part 2
Hilary Till, Premia Capital Management, LLC, Chicago; and Research Associate, EDHEC-Risk Institute, Nice (France)
Hilary Till is the co-founder and principal of Premia Capital, a proprietary trading and research firm in Chicago. She is also the co-editor of the book, Intelligent Commodity Investing; a member of the North American Advisory Board of the London School of Economics, and is a Research Associate at the EDHEC-Risk Institute in Nice, France.
Please note: Due to length, this article is running in two issues of AIQ; the first part of the article ran in Issue 33 of AIQ: this is the second and final part of the article.
Historical skepticism regarding futures trading
The reader may grant all of the various fundamental explanations regarding the oil-price spike in 2008, but still say, ‘Yes, but what about the speculators?’ In reviewing historical studies since 1941, one realises that this topic may always be an area of controversy. When one reads the landmark US Department of Agriculture (USDA) (1941) study by Hoffman and Duvel on the impact of futures trading on grain prices, one is struck by how the terms of the debate on futures trading have not changed in seven decades. Further, when one reads US Congressional testimony from 1892, as cited in Jacks (2007), one realises how during times of intense competitive dislocation, as also occurred during the last great era of globalisation, that the social usefulness of futures trading has historically been called into question.12 Similarly, Sanders et al (2008) note how the intense price rises of the 1970s also resulted in public pressure to curb futures trading.13
A later section of this article will cover the plausible short-term effects of futures trading on commodity prices. But first we will draw some preliminary conclusions from the fundamental data and price histories that we have presented thus far.
Preliminary conclusions: data transparency
[1] In Issue 33, we showed several well-chosen price charts and news reports to indicate that pre-Olympic stocking may have contributed to the oil-price spike in the first half of 2008. Obviously, it is inappropriate for us to say we proved this assertion. That said, we can point to one unambiguous conclusion: given how finely balanced global oil supply and demand had been in early 2008, we would note that it would be extremely helpful for China’s demand and inventory statistics to eventually become as transparent as those in the OECD, in co-ordination with the IEA. The IEA is already working cooperatively with non-OECD consumers (such as China) and non-OECD producers (such as Saudi Arabia) through the Joint Oil Data Initiative (JODI) to provide more transparency on oil statistics. In fact, this was one of the key policy statements that emerged from the 22 June 2008 Jeddah (Saudi Arabia) Summit on the global energy markets, which included leaders from both oil consuming and producing countries.14 Appendix A from the JODI shows the progress in signing up countries to provide empirically sound statistics on the oil markets.
We can draw three other subsidiary conclusions as well, all of which are related to how crucial data transparency in the oil market is and will be.
[2] In examining futures market price signals from the spring of 2008 onwards, we would conclude that the futures markets had once again provided alert participants with useful, concurrent information on underlying demand in the opaque oil markets, rather than participants having to wait several months for a coherent, fundamental explanation.
That said, we have to caveat this statement. Fundamental structural changes occur constantly in
the commodity markets, including in the petroleum complex. The interpretation of a price relationship
is sometimes conditional on a particular state-ofthe-world. A concrete example should make this statement more clear. This example is in Appendix B to this article.
[3] It is clearly not a good state-of-affairs for oil to have been in such a tight balance that: (a) an extraordinary (and temporary) demand event could plausibly have caused oil prices to increase at such an extraordinary pace; and (b) supply disruptions in well-known unstable parts of the world could have caused oil prices to spike to over $250 per barrel, as discussed in scenarios by Blanco and Aragonés (2006).
Regarding the latter point, and consistent with the theme of data transparency, it would be extremely helpful if reserve and productive capacity information from key oil exporters were not so opaque, as discussed in Khan (2008). For example, is Saudi Arabia incapable of serving its historical role as swing producer?15 That said, when oil markets have been so finely balanced, even marginal additions of supply have had a disproportionately positive impact on price. During the 22 June 2008 Jeddah Oil Summit, Saudi Arabia announced that it would increase production by an additional 255,000 barrels per day in July and by more than 200,000 barrels a day in June, according to Reed (2008). Promoting openness (ie, data transparency) is one of the core principals described in the June 2008 paper, ‘Global Commodities: A Long Term Vision for Stable, Secure and Sustainable Global Markets,’ by the United Kingdom’s Treasury Group.16
[4] In the absence of key (timely) fundamental data from non-OECD countries, one can rely on the transparency of commodity futures markets to infer what the concurrent and future expectations are regarding the oil supply-and-demand balance, as noted in point [2]. It would, therefore, be extremely unfortunate if US public policy were to limit oil futures trading, resulting in these markets becoming even more opaque.
Now, to be fair to critics of futures trading, this activity is arguably not sufficiently transparent either, at least by the standards originally established by the US Congress in the Commodity Exchange Act of 1936. This is an area that the US Commodity Futures Trading Commission (CFTC) has been addressing and whose progress was initially described in Dunn (2008). The CFTC is examining not only the opaque over-the-counter (off-exchange) energy derivatives markets, but also energy futures trading in London, in those specific cases where the contracts are tied to US delivery locations. This energy trading takes place on the ICE Futures Europe exchange. It may be that the CFTC will need additional legislative authority (and funding for staffing) before these monitoring functions become a regular part of the CFTC’s responsibilities. Obviously, also, the gathering of, and the publication of, data on energy futures trading in London requires co-operation with the UK regulatory body, the Financial Services Authority (FSA).
Mini Prime Brokerage
Alexandra R. Barbier, JP Morgan, London
Alexandra Barbier currently works at JP Morgan within derivatives collateral management as a Relationship Manager in London. Alex worked for Merrill Lynch & Co Inc for two years as a client services representative within the prime brokerage front office. Prior to this, she worked at Goldman Sachs International for six years where her last role was as a client services representative in the prime brokerage front office, where she was the primary contact for multi-billion dollar hedge fund clients.
Post-credit crisis, the landscape for hedge funds and prime brokerage has undergone a dramatic transformation. With ambiguity still looming overhead in terms of the Alternative Investment Fund Managers (AIFM) Directive, it has been a year for re-vamping, re-capitalisation and re-structuring for hedge funds and prime brokers globally. Having been part of the redundancy culls in 2009, I have kept in touch with a couple of ex-clients, one of whom liquidated during the crisis. Another was facing a large minimum fee from their prime broker and needed to find another firm who could clear the fund’s business, while keeping costs to a minimum in light of their fairly new track record.
The hedge fund in question mentioned the mini prime brokerage (PB) space to me as a means of clearing their own business, but also as a potential new employer. Merlin Securities is shortly due to open offices in London following continued growth and expansion as a now mid-sized PB. The client felt largely marginalised in terms of the service offering the fund was receiving, but understood that they could not compete with the larger hedge funds they knew dominated their PB’s books. With a mini PB, smaller funds are able to not only access more competitive pricing in terms of clearing and execution services, but also a far superior service offering in terms of optimised day-to-day interaction with the nominated client services representative. The mini PB targets small- to mid-sized funds, so they are familiar with servicing this type of client and are able to handhold many of the start-ups who often require additional focus and support, not only in terms of assisting operational staff with any training issues, but also helping with software solutions — ranging from order management systems to accessing global trading platforms.
To give some background in relation to the rise of the prime broker, the first non-US prime brokerage business was created by Merrill Lynch’s London office in the late 1980s, and this phenomenon quickly ballooned in through the 1980s and 1990s with the advent of the hedge fund business model. The idea of a hedge fund and the concept of short-selling was introduced in 1949 by a gentleman named Alfred Winslow Jones. He first started the concept of employing leverage and the idea of managers taking a performance fee. Jones set up an investment vehicle in the 1940s and commenced buying and selling stocks. He preferred not to take a commission from his clients and, instead, opted for a 20% share of any profits he was able to generate.
Following the 2008 financial crisis, we have seen a re-structuring of the prime brokerage industry with a down-sizing in terms of the number of major PBs in the market. We saw the collapse of Bear Stearns and its subsequent absorption into JP Morgan, the merger of Merrill Lynch with Bank of America, and Barclays’ acquisition of Lehman’s North American business after the 2009 crash.
Hedge funds are also increasingly aware of the need for diversification; gone are the days of a sole PB managing a hedge fund’s assets. This is overwhelmingly due to the need to address the issue of counterparty credit risk; a hedge fund manager would look to safeguard his strategy by ensuring his strategy was not overly ‘visible’, ie, through diversification. Here, again, the mini PB can offer the ability for smaller funds to utilise a multi-PB strategy. The infrastructure typically needed for this can be costly, however, the whole concept of a mini PB is to introduce a cost-saving element and enhanced client service. The mini PB acts as the sole interface with the client to track the different accounts.
Mini PB’s have largely been a US phenomenon, and I spoke to Ron Suber, Head of Global Sales at Merlin to understand how their business model works.
Merlin is a privately held, five-year-old, technology intensive prime brokerage services company with 80 employees and 450 clients. The vision for the firm was to enable hedge funds with less than $1 billion AUM to multi-prime their assets, operate smoothly and articulate their edge vis à vis the larger hedge funds in the market who exceed the $1 billion threshold. Merlin uses Goldman and JP Morgan to clear and custody their client’s business while still retaining the front-office relationship directly with their clients. The fact that Merlin is using major household names within the PB industry gives an added layer of comfort to investors whilst also offering competitive pricing and addressing the ‘affordability factor’ that small- to mid-sized funds often face. To note Merlin clients are also able to choose which PB they wish to custody their assets with, ie, JP Morgan, Goldman or Northern Trust. Aside from the core custody and clearing services that Merlin provides, they also offer the full range of services typical of a large-scale prime broker such as financing, intra-day portfolio reporting, stock loan, capital introduction and risk management. In addition, they look to help start-up funds and have a nine point check list for funds when attracting new institutional investors. With the increased focus around corporate governance, transparency and enhanced reporting there is certainly a need to cover all bases in terms of producing a thorough and comprehensive picture to potential investors of what differentiates one fund from another.
Hedge Funds: A Risk Manager's Viewpoint
Frances Cowell, R-Squared Risk Management, London
Frances Cowell is Director of Risk Consulting at R-Squared Risk Management, an independent, specialist risk management firm. Frances also serves on the board and is Company Secretary and Treasurer of London Quant, an organisation that provides a forum for discussion of practical issues in quantitative investment techniques. She is an Associate Member of the Chartered Institute for Securities and Investment and a member of CFA UK.
Asking the right questions
Regulators on both sides of the Atlantic are seeking to protect investors with new regulation to capture all investment products, including hedge funds and absolute return funds that have, until now, been largely unregulated. Whatever the outcome, it is up to investors to satisfy themselves that the risks taken by their managers are justified by the expected returns. The key is to ask the right questions.
There are good arguments both for and against regulation. Well thought-out controls can improve the information available to investors and, therefore, increase their confidence. Poorly contrived regulation merely increases management costs and raises the barrier-to-entry for new and potentially innovative products, which hurts investors by increasing costs and reducing the choices open to them. Ill-conceived controls can also impose a drag on performance by reducing the manager’s scope to achieve the best return-to-risk balance; and — worst of all — can even have the paradoxical effect of increasing the risk to investors by giving a false sense of security.
One of the priorities of regulators is to prevent a repeat of the catastrophic losses that caused so much damage in 2007 and 2008. But, is this aim realistic? It is worth remembering that, while the sources of the meltdown are still being debated, few believe that it originated with hedge funds. Two possible culprits, banks — responding to very low interest rates — and the mortgage market, were already well-regulated and supervised. Large banks ran daily stress tests and scenario analyses that failed, at the time, to tell them how vulnerable they actually were.
Nevertheless, the nominal size of hedge fund investments arguably warrants a closer look, and the catastrophic losses incurred clearly point to widespread failure of risk management. Ultimately, whether regulators provide effective controls and supervision for this genre of fund or not, it is the responsibility of investors to see that the returns they get from their investments warrant the risks that are taken. Relying solely on regulators for your peace of mind is like relying solely on traffic signs when you drive your car: definitely better than nothing — providing the lights are functioning — but no substitute for looking where you are going. What, therefore, should you be looking for?
We are frequently reminded of the ‘bewildering’ range and complexity of hedge fund strategies. Whether you think they are bewildering or not, they are by no means uniform. Despite this diversity, due diligence and governance processes typically comprise a set of standard questions, many to do with risk measures. These processes are both necessary and valuable, and much of the data they gather add genuine insight into the risks of some funds. But risk measures that are not directly relevant can distract from the real issues. They also often belie a premise that the less risk there is, the better. Does this make sense?
Commonsense tells you that attractive returns can be earned only by taking risks. Risk is what drives your return. In general, if you minimise risk, then you minimise your return, so it is odd to seek a blanket reduction in risk.
Recognising the inseparability of return and risk is the key to risk management: risk should be accepted only if it is expected to lead to extra return. If it is, it should be nurtured and managed. If it is not, then it should indeed be eliminated. The aim of risk measurement is to understand which is which. Failure to do so allows potentially lethal sources of risk to go unnoticed — and therefore unmanaged — leaving the fund vulnerable to catastrophic losses.
This is the question you should aim to answer. But few fund fact sheets or performance and risk reports volunteer this information in an easy-to-understand way. So you need to be clever to find out what you need to know. A few ‘rules of thumb’ can be helpful.
1. Risk management is not the same as risk minimisation. The objective is to manage risk, not necessarily reduce it.
2. Risk measurement should be comprehensive, and include all risk that is ultimately borne by the investor; including gearing and counterparty risk, as well as market and factor risk, as these risks can, in turbulent markets, compound eac h other. This is important, whether the overall risk measure is value-at-risk (VaR), conditional value-atrisk (CVaR), tracking error or volatility.
There is no unambiguously ‘best’ measure of risk. VaR, CVaR, tracking error and volatility are essentially measures of a return (profit or loss) associated with a probability over a given time frame, such as 95% probability over one month. They each conceal as much as they reveal. Questions you might want to ask are:
- Do they measure the likelihood of your target return being achieved, or are they only measuring the likelihood of extreme loss? A 95% VaR for example, indicates a loss that is expected to happen about once every 20 years. This tells you nothing about how the fund might behave in normal market conditions (in other words, most
of the time). To understand the likelihood of achieving your target return, you would look toward the
standard volatility measure (or tracking error if the fund is compared to a benchmark). Of course, if you really are interested only in avoiding extreme losses, you would leave your money in the bank! - Is the time frame suitable? A one month VaR is of limited use if your investment horizon is three years (and vice versa).