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The Risks of Portfolios of Hedge Funds

The Risks of Portfolios of Hedge Funds. Drago Indjic Fauchier Partners. PRMIA, 14 May 2003, London. Don’t believe everything you read Negative media bias Cliché: “LTCM”, “Soros”, “Courtisans” … = Investor education, academic research . Speculators. 1. El Pais, 24 Feb 2003.

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The Risks of Portfolios of Hedge Funds

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  1. The Risks of Portfolios of Hedge Funds Drago Indjic Fauchier Partners PRMIA, 14 May 2003, London

  2. Don’t believe everything you read Negative media bias Cliché: “LTCM”, “Soros”, “Courtisans” … = Investor education, academic research Speculators 1 El Pais, 24 Feb 2003

  3. Early 21c. Risk 2 Source: HFR, Pertrac, Fauchier

  4. Content 3 • Hedge fund industry • Investment strategies • Investor’s perspective • Data, Transparency and Estimation Risks • Hedge fund risk • Portfolios of Hedge funds(Any HF investors or FoHF in the audience?)

  5. Hedged Funds 4 • Unregulated private placements • (e.g.) A pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public • “Extralegality” (de Soto) => Frontier Creativity • Less restrictive liquidity, borrowing, derivatives … (taxation) • Creative investment strategies – efficient capital utilisation • Perpetual innovation ⇄ inefficiencies • Consider only hedged (off-shore) funds

  6. Industry 5 • The most dynamic sector of asset management today • Decreasing sell side research coverage; Higher servicing profitability • Regulators “lagging” • SEC: May 14/15 – “raising bar”? • Sustained growth • Highly creative and talented manager’s end game: “personal” styles • Owner/Manager mentality • Self-Regulation by adapting capacity, liquidity, fees

  7. Estimated Number of Hedge Funds (ex FOF) 1990 - 2002 Estimated Hedge Fund Asset Growth and Flow 1990 - 2002 6 Assets (In $MM) Number of Funds Estimated Assets Asset Flows 2003

  8. Hedge Fund Environment 7 • Tass Asset Flows Report™ 4Q2002 3493 total -1337 “dead”=2156 “live” funds • HFR 2002 Industry Report: 4598 funds (exc. FoF) (AUM most probably underestimated)

  9. Another Asset Class? 8 • Contra: • HF are “alternative investment strategies”: too heterogeneous, dynamic, evolving, with no brands • Pro: • Absolute returns paradigm, Ineichen (2002) • Specific liquidity (“mark-to-market”) and drawdown preferences • Very different sources of α, uncorrelated, –ve β, better Ω … ran by non-consensus thinkers in small enterprises

  10. Investment Strategies 9 • Hedge Fund (HF) “Indexes” • Composites of actively managed portfolio returns • Over a dozen commercial indices • Investible? Transparent? Capacity? • No independent verification • Enforcing “relative” rather than “absolute” return viewpoint • Evolving strategies • E.g. Quantitative credit arb, macro equilibrium models • Many styles within strategy (inc. different fund of funds styles) • “Strategy drift” detection

  11. Estimated Strategy Composition by AUM 1990 Estimated Strategy Composition by # of Funds (ex FOF) 2002 10 2003

  12. Estimated Net Asset Flow by Strategy 2002 Estimated Net Asset Flow by Strategy Q4 2002 11 Fund of Funds 2003

  13. 2002 HFRI Index Risk Return Comparison 5 Year Annualised (1998 – 2002) 2002 HFRI Index Risk Return Comparison 12 2003

  14. AIMA Strategy Definitions 13 • An index family for every commercial data source: too many indices but a lack of definitions • Ad-hoc committee under the under the auspices of AIMA called for “Expressions of interest” in April 2003 • ‘Non-commercial’, coordinated long-term research effort leading to the development of a set of definition "guidelines" • Survey planned during 3Q03

  15. Creating Exposure 14 • How? • “DIY”, advisor, specialist? • “Fund of funds” (FoHF) route • Passive: Indexed • Pools of managed accounts • Which “index” and “HF Tracking error”? • Active: Portfolio of funds • “Off the shelf” • Tailor made and managed • Structured • What type of security do you own? • Total costs?

  16. FoHF Examples 15 • Two hedge funds • A Hedge fund Index, S&P 500-hedged • Selection of a dozen funds from “platform”, wrapped • Five funds, 8 x levered portfolio • Single-strategy, multi-manager (levered) • Any including a fund that rebates 50% of fee to anyone

  17. Investment Biases 16 • Business rather than investment management: • Seeding, incubation, equity stakes • Capacity marketing, fees splits • Selection vintage year • Asset gatherers: • Collecting fees on gross assets? • Layered fees transparency (e.g. structured products) • 2nd level Performance fee • Hurdle, Highwatermark

  18. Managed Account “Platforms” 17 • Collection of HF accounts – a trivial solution? • Portfolio construction biases • “Products” or portfolios? • Captive market? • Can “good” funds be included? • Where is manager self-invested? • Should “on going” Due Diligence be outsourced?

  19. Data and Modelling 18 • Data: not liquid market prices but performance estimates of “hyperactive” portfolios skilfully managed in different, very personal styles • Problematic valuation: IAFE Hedge Fund Valuation Practice recommendations • Hedge fund strategy modelling • Multifactor models: R2 from 0.1 to 0.9? • Option replication (Naik and Agrawal, 2001) • Calibration: NAV (RiskData) or model exposure data

  20. Transparency Debate 19 • No unique answer • “Those people who need it will find managers who will provide it” • “Those managers who won’t give it will be able to find investors who don’t need it” • Greatest fear: hedge fund ruin (default) • Aggregated disclosure • Mutual trust: the “agent” in real-time dialogue • Full Transparency Paradox • Un-actionable without active overlays • Diminishing need for managers if operating “active” overlay?

  21. Long/Short Equity Report Template Hedge Fund Exposures 20 Source: Fauchier

  22. Transparency Compliance (2002) 21 Source: Fauchier

  23. Taboo topic: non-asymptotical statistics, very short and noisy data samples Volatility and VaR – Figlewski (2003) Portfolio - Kempf (2002) The equal weighting is theoretically optimal solution when data and forecasts are not reliable Estimation Risk 22

  24. Small sample bias 23 • Estimate correlation: n=12 data points: “ρ=0” ↔ ρ∊[-0.3, 0.3] (85%) “secretary problem” - but fund may be already closed

  25. Correlation Matrix 1 April 2001 to 31 March 2003 24 Source: Fauchier

  26. Weekly vs Monthly Data View 25 Surprising differences in certain fund correlations pairs Source: Fauchier

  27. Weekly HF “Indexes” 26 Equally weighted index of weekly returns: non-normality Source: Fauchier

  28. Omega Ratio 27 Keating and Shadwick (2002)

  29. Hedge Fund Risk 28 • HF are SME (~7 people => no IT, client service …) • Can portfolio manager run (grow) a small business? • “Disgraceful aging” • Total Hedge Fund Risk = • Market Risk + Operational Risk • Operational Risk >> Market Risk • Principal/Agency Problem • Balance “Qualitative and Quantitative” Risks

  30. The Real Risk 29

  31. Risk Management 30 • Primary (individual hedge fund level): • Many market risks are (most often) hedged • Balance sheet dynamics: leverage and hedge skills • Kept in check by Prime Broker margin policy • Secondary (portfolio of funds level): • Risk measurement + portfolio management • Operational risk management

  32. Market Risks 31 • Mandatory: Prime brokers • Are VaR and margin policy private information not to be disclosed (timely) to (all) investors? • Optional: Third party “Risk aggregators” • HF → TTP → Investor • New generation fund administrators? • Voluntary: Customised risk reporting • IAFE IRC and AIMA: Strategy-specific templates

  33. Operational Risks (1) 32 • Age and stability • Immature business models • Incentives, succession planning • Capacity • “Chicken & Egg” capacity games: • Day 1 fund closures, secondary market • Big isn’t beautiful: median AUM $40m • “Know your client”: max. two dozen investors • Liquidity • Lockups, penalties, gates, suspended and forced redemption rights

  34. Operational Risks (2) 33 • Organisational Structure • Legal structure • Performance fee models • Counterparties • Fund administration, Audit, Prime Broker • Manager Utility: “Path-Dependant” • Risk aversion = f ( ΔAUM, Losing streak, YTD, Wealth…)

  35. Funds of Hedge Funds 34 • FoHF A ≠ FoHF B • % own (or owned) funds, %funds of funds, % multi-strategy funds … • Liquidity, costs (fee sources) • Portfolio Analysis • Performance Attribution: Manager selection vs Strategy allocation • Turnover (usually low), ROCE • Style analysis • Monitoring • In-situ: business and operational risk

  36. Portfolio Construction 35 • “One size doesn’t fit all” • Single-strategy, multi-manager: mitigate decision making? • “All weather” • Tailor-made • Levered or not? • “Optimised” or not? • Avoid behavioural biases

  37. Kempf (2002): Optimal portfolios for data length T, market inhomogeneity τ, identical prior mean. Portfolio Estimation Risk 36 • Comment: funds of hedge funds are in T→0/τ→∞

  38. Portfolio Construction 37

  39. Operational Risk Optimality 38 • Constrained optimisation • Asymmetric calendar trading constraints (illiquidity) • Inherent slippage • Not mean-variance but scheduling and constraint programming • Monitoring Costs: Communication density • #meetings/funds/year/analyst(s)

  40. Calendar Liquidity Constraints 39 M/M+30/15 Sept 03 March 04 Jan 03 July 03 Nov 03 Jan 04 March 03 May 03 M/M+60/20 March 04 Sept 03 Jan 03 Jan 04 July 03 Nov 03 March 03 May 03 2/Q+60 March 04 Sept 03 Jan 03 Jan 04 July 03 Nov 03 March 03 May 03 Source: Fauchier

  41. Manager Research and Monitoring 40 Number of meetings Total number of meetings Source: Fauchier

  42. Conclusion 41 • Balance true risks and costs • Attention to vested business interests and incentives (are we all “eating our own cooking”?) • Quantitative, but also confident • Product divergence • “Optimal” transparency • Commoditisation vs customisation

  43. Bibliography - Introduction 42 • AIMA (2002) A Guide to Fund of Hedge Funds Management and Investment • AIMA (2003) Hedge Fund Strategy Definition Standardisation • Inechien, A. (2002) Absolute Returns, Wiley • L’ Habitant, F.-S. (2002) Hedge Funds: Myths and Limits, Wiley • Rahl, L. (2003) Hedge Fund Risk Transparency, Risk Books

  44. Bibliography - Research 43 • Figlewski, S. (2003) Assessing the Risk in Risk Assessments, IAFE/ PRMIA Seminar, April 23rd, NYC • Kempf, A., Memmel, C. (2002)On the Estimation of the Global Minimum Variance Portfolio, Discussion Paper 2002-2, Uni. Koeln • Keating, C., Shadwick, W. (2002) “Omega: A Universal Performance Measure” Journal of Performance Measurement, Spring 2002 • Lo, A. (2002) Risk Management for Hedge Funds: Introduction and Overview, AIMR • Naik, N., Agrawal, V. (2001) Performance Evaluation of Hedge Funds with Option-based and Buy-and-Hold Strategies, LBS

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