Alternative investments

Transcription

journal of financial transformation
04/2004/#10
journal
the
Risks
Opportunities
Private equity
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Editor
Shahin Shojai, Director of Strategic Research, Capco
Advisory Editors
Predrag Dizdarevic, Partner, Capco
Bill Irving, President, Capco
John Owen, Partner, Capco
Editorial Board
Franklin Allen, Nippon Life Professor of Finance, The Wharton School,
University of Pennsylvania
Jacques Attali, Chairman, PlaNet Finance
Joe Anastasio, CEO, Cross Border Exchange, and Partner, Capco
Philippe d'Arvisenet, Group Chief Economist, BNP Paribas
Rudi Bogni, Former Chief Executive Officer, UBS Private Banking
David Clark, NED on the board of financial institutions and a former
senior advisor to the FSA
Elroy Dimson, Professor of Finance, London Business School
Nicholas Economides, Professor of Economics, Leonard N. Stern School of
Business, New York University
Michael Enthoven, Chief Executive Officer, NIB Capital Bank N.V.
George Feiger, Executive Vice President and Head of Wealth Management,
Zions Bancorporation
Jordan W. Graham, Managing Director, Financial Services Industry,
Internet Business Solutions Group, Cisco Systems, Inc
Wilfried Hauck, Chief Executive Officer, Allianz Dresdner Asset Management
International GmbH
Alasdair Haynes, Chief Executive Officer, ITG Europe
Anthony Kirby, Head of STP Design, Group Functionality, Deutsche Börse AG
Thomas Kloet, Senior Executive Vice-President & Chief Operating Officer,
Fimat USA, Inc.
Herwig Langohr, Professor of Finance and Banking, INSEAD
Mitchel Lenson, Global Head of Operations & Technology, Deutsche Bank Group
Donald A. Marchand, Professor of Strategy and Information Management, IMD
®
and Chairman and President of enterpriseIQ
Colin Mayer, Peter Moores Professor of Management Studies, Saïd Business
School, Oxford University
Robert J. McGrail, Chairman of the Board, Omgeo
Jeremy Peat, Group Chief Economist, The Royal Bank of Scotland
Jos Schmitt, Partner, Capco
Kate Sullivan, Chief Operating Officer, e-Citi
John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund
Graham Vickery, Head of Information Economy Unit, OECD
Norbert Walter, Group Chief Economist, Deutsche Bank Group
TABLE OF CONTENTS
THE NOBEL LAUREATE VIEW
8
The future of hedge funds
Myron S. Scholes
Chairman, Oak Hill Platinum Advisors
Frank E. Buck Professor of Finance, Emeritus,
Stanford University
Co-winner of The Bank of Sweden Prize in
Economic Sciences in Memory of Alfred Nobel 1997
OPPORTUNITIES
74
Opinion: An E.U.-wide passport for hedge funds
John Purvis, Member of the European Parliament,
and Vice-President of the Economic and Monetary
Affairs Committee
80
Opinion: A single market for hedge funds
Wolfgang Mansfeld, President, FEFSI
82
Opinion: Marketing of hedge funds in Switzerland
Shelby R. du Pasquier, Partner, Lenz & Staehelin,
Geneva
87
The hedge fund revolution
R. McFall Lamm, Jr., Chief Investment Strategist and
Head of Global Portfolio Management, Deutsche Bank
Private Wealth Management
97
Hedge funds in Asia
Peter Douglas CAIA, AIMA Council Member for
Singapore, Principal, GFIA pte ltd, and Research
Director, Dewey Douglas Ltd.
107
Key findings of the Edhec ‘European Alternative
Multi-management Practices’ Survey
Noel Amenc, Professor of Finance, Edhec Business
School and Research Director, Misys Asset
Management Systems
Jean-René Giraud, CEO, Edhec-Risk Advisory
RISKS
14
18
Opinion: Size vs. performance in the
hedge fund industry
James R. Hedges, IV, President and
Chief Investment Officer, LJH Global Investments
Opinion: Crisis management for the financial
services industry
Charlotte Luer, President, LJH Financial Marketing
Strategies
Samuel Wang, Global Head of Marketing and PR, Capco
23
The role of hedge funds for long-term investors
John M. Mulvey, Professor, Bendheim Center for
Finance, Princeton University
31
Finding the sweet spot of hedge fund diversification
François-Serge Lhabitant, Member of Senior
Management at Union Bancaire Privée, and a Professor
of Finance at HEC University of Lausanne (Switzerland)
and at EDHEC Business School (France)
Michelle Learned De Piante Vicin, Analyst, Alternative
Asset Advisors - 3A
41
Valuation issues and operational risk in hedge funds
Christopher Kundro, Partner, Capco
Stuart Feffer, Partner, Capco
49
Hedge funds and U.K. regulation
Ashley Kovas, Manager, Business Standards
Department, Financial Services Authority
57
67
Should you, would you, could you invest
in hedge funds?
George Feiger, Executive Vice President and Head of
Wealth Management, Zions Bancorporation
Pascal Botteron, Head of Hedge Fund
Products Structuring, Pictet Asset Management
Shadow accounting: The evolving practice of
exercising due diligence in fund reporting
Carol R. Kaufman, President, InvesTier operating unit
of SunGard Investment Management Systems, Inc.
PRIVATE EQUITY
116
Opinion: Private equity - An industry in
transformation
Tycho Sneyers, Head of Business Development,
LGT Capital Partners
121
Initial returns and long-run performance of private
equity-backed initial public offerings on the
Amsterdam Stock Exchange
Ruud A.I. van Frederikslust, Associate Professor of
Finance, Rotterdam School of Management, Erasmus
University Rotterdam
Roy A. van der Geest, Mergers and Acquisitions
Consultant, Holland Corporate Finance
129 Leveraged management buy-ins: Role of investors,
means of exit, and the predictive powers of the
financial markets
Shahin Shojai, Director of Strategic Research, Capco
Rhetoric does not go far enough
Much of the rhetoric surrounding hedge funds that makes the headlines is astonishingly polarized. This may
be because most commentators simply do not understand them or because their activities and the apparent
complexity of some of their trading strategies defies simple explanation and debate. Whatever, the reason,
good or bad, no-one on either side of the debate denies that they exist, that they and the wider alternative
investment market has grown substantially in recent years, and that they are a significant part of the financial services industry.
Personally, I have always welcomed innovation in our industry. Indeed, the rapid pace of innovation has long
been a dominant characteristic of the financial services industry and one that makes it an attractive working
environment for many of us. The challenge, of course, is to harness this innovation, to balance the pace of
change with the maintenance of appropriate business controls, and to innovate without undermining operational efficiency.
At Capco, we are not interested in whether hedge funds are good or bad. We are interested in helping them,
and other alternative investment vehicles, become successful businesses. To do that requires an in-depth
understanding that goes way beyond rhetoric. That is why we recently conducted the in-depth study into the
root causes of hedge fund failure that is summarized in the article on valuation and operational risks in hedge
funds in this journal. That is also why we decided to make alternative investments, and hedge funds in particular, the focus of this issue.
Whether we are comfortable with it or not, the alternative investment sector will continue to grow. As it does
so more and more of us – customers, counterparties, consultants, and suppliers - will have to understand in
much more depth the structures, strategies, and operational risks involved. None of us can afford to rely upon
the rhetoric alone.
I trust that the insights presented in this issue will help move the debate beyond the headlines and that they
will, as always, challenge and stimulate your thinking about this important sector.
I hope that you enjoy this issue.
Rob Heyvaert,
Founder, Chairman and CEO, Capco
The hedge fund phenomenon
It is quite remarkable how hedge funds have become the buzz word in today’s world of high finance. Whether
you love them or hate them, you cannot deny the attention they are getting from the trade and popular press,
and of course the investment community. It is not, however, only the complex investment styles of hedge funds
that is grabbing the attention of the world’s major investment managers. Similar to the trading desks of the
major investment banking institutions, they are also facing serious threats from star departures. Lured by the
extremely attractive compensation packages, at least of those people who really make the news, and of
course not of those who lose their shirts in the process, fund managers and arbitrage desks experts are flocking to join or create their own hedge funds. This brain drain is a serious issue for both of these types of institutions, and they need to find a solution before it really does become too late for the traditional players in this
industry.
That is why we have dedicated this whole issue to alternative investments. Please note that we are in no way
suggesting that hedge funds represent all of the alternative investment universe; by no means, that is in fact
why the last section of this issue has also got a number of articles on private equity. But, the fact is that today
hedge funds have become synonymous with alternative investments. So much so that most other alternatives
are overlooked. We would like to assure you that had the number and quality of the articles we received on
the topic of hedge funds not been so great, we would have been more than happy to include papers on the
other types of alternative investments. However, the passion for and against these vehicles was so strong that
we were compelled to give them a lot more coverage than we had initially anticipated. We hope that other
alternative investment vehicles will forgive us for this oversight.
In addition to a number of really interesting articles for and against hedge funds, and in fact private equity,
we are very honored to have one of the world’s foremost financial economists write for the Nobel Laureate
View Section of this issue. In fact, it is hard to imagine how many of todays highly exciting hedge funds would
have been created had it not been for this man’s seminal paper on valuing derivative products. Prof. Myron
Scholes, one of the two authors, with the late Prof. Fischer Black, of the seminal papers on derivatives pricing, and more importantly the recognition of arbitrage pricing, is undoubtedly one of the most influential people in the world of finance, and we are truly honored that he chose our journal to give his views about this
new phenomenon.
We really hope that you will enjoy this issue of the journal and continue to support us by submitting your best
ideas to us.
On behalf of the board of editors
THE NOBEL LAUREATE VIEW
The future of hedge funds
Myron S. Scholes
Chairman, Oak Hill Platinum Advisors
Frank E. Buck Professor of Finance, Emeritus, Stanford University
Co-winner of The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1997
Why do institutional investors allocate less than 5% of their
Hedge funds are increasing in numbers and in assets as a
assets to hedge funds? That is the question that most of the
growing number of risk managers at banks and within the
proponents of hedge funds ask the investment community.
broker-dealer community are leaving to establish hedge
I believe there are many reasons for this, but I will list only a
funds. Traditionally, financial intermediation services, such as
few of them in this paper. Hedge funds were not initially
liquidity provision and risk transfer services, had been provid-
designed with institutional investors in mind, but were origi-
ed almost exclusively by financial institutions. Currently, how-
nally organized as partnerships to attract high net worth indi-
ever, traditional financial institutions prefer to earn fees more
viduals. They use leverage, sell securities short, and charge
so through agency and less so through risk-taking activities.
incentive fees based on the performance of the fund. This
Hedge funds are taking up the slack and may be more suited
structure is not well-suited to institutional investors, such as
to supply the capital necessary to support these risk-taking
pension funds and endowment funds, mainly because invest-
activities. This has lead to a growing talent base in the hedge-
ing in a leveraged partnership structure subjects the U.S. tax-
fund universe, talent that has expertise in running leveraged,
exempt institutional investor to so-called, ‘unrelated business
long-short strategies and providing returns that exhibit low
taxable income.’ Moreover, unless a hedge fund registers with
correlation with returns on index-fund products. This talent
the U.S. Securities and Exchange Commission as an invest-
base has attracted institutional investor capital.
ment company, the U.S. Department of Labor ERISA rules
might prevent hedge funds from receiving incentive fees on
Prior to this exodus of talent, hedge funds as a whole could
hedge fund returns unless these institutional investors consti-
not earn sufficient returns to invest the inflow of capital that
tute less than 25% of the assets of the hedge fund. Although
would result if institutional investors held a large proportion
financial engineering and structuring can reduce the impact
of their invested capital in alternative investments. There is a
of these restrictions, they are binding constraints in many
delicate balance between the returns that can be earned from
instances.
hedge funds and the capital supplied. Generally, the larger the
capital supplied to any investment, including hedge funds, the
Institutional investors have generally invested in securities. In
lower the returns and, in turn, the flow of capital into that
the past, they might have considered investing in hedge funds
investment will fall. Extra capital, however, attracts talent and
to be imprudent. More modern thinking, however, considers
this enables hedge funds to provide additional services. The
portfolio returns and risks and not the constituents making up
financial intermediation business, which includes hedge
the portfolio. Hedge funds might have risk and return charac-
funds, requires a combination of talent to assess the level of
teristics that enhance portfolio return-to-risk characteristics.
capital to provide for liquidity provision and risk transfer, and
Institutional investors have also come to realize that long-only
an ability to convince other capital suppliers that the requisite
managers, such as mutual funds and banks, tend to hold large
returns will be available to them.
diversified portfolios that after fees, earn less, on average,
than naïve investment strategies, such as investing in indexed-
Fund-of-funds provide a diversified collection of underlying
asset classes. They are paying for services that do not pro-
hedge funds for investors. A single hedge fund with only one
duce enhanced returns. As a result, they are moving to obtain
line of business will suffer large losses from time to time.
active management exposures through investing in hedge
These so-called ‘draw downs’ are the natural consequence of
funds, private equity, and real estate, and passive exposures
providing intermediation services in specific areas. Most sin-
through index products.
gle strategies could suffer draw downs approximately equal to
one-year’s returns in a short period of time. A 10% draw down,
8 - The
Journal of financial transformation
for example, might cause investors to leave the fund at the
The real value added of the fund-of-fund advisor is to allocate
worst time for those funds that invest in negative feedback
investors’ funds strategically among alternative hedge funds.
strategies. When the returns to providing intermediation serv-
Given that the underlying activities are complicated, dynamic,
ices are greatest, the capital might move to new investments.
evolutionary, and may even be subject to extreme shocks
It is hard for outsiders to deduce whether the losses were due
from time to time, these advisors economize on the time and
to external circumstances or lack of skill. As a result, most
effort necessary to make the dynamic allocation decisions. In
funds try to provide services in more than one strategy in
other words, it would not be economic or efficient for every
order mitigate, through diversification, the draw down risk of
investor to perform these functions. Moreover, these advisors
their total portfolio.
warrant that the smaller hedge funds do provide services that
capital providers should support.
As a hedge fund expands its strategies, it becomes a multistrategy fund. A fund-of-funds is a multi-strategy fund that is
Hedge funds activities are mainstream. They replace or sup-
built by investing in many independent hedge funds. There are
plement existing activities in the market. Many hedge funds
advantages to both routes for diversification and risk reduc-
attempt to earn abnormal risk-adjusted returns, in the ver-
tion. The multi-strategy fund can dynamically allocate among
nacular, generate alphas, by forecasting cash flows, growth
its strategies to enhance returns.
rates, and discount rates on these flows with more skill than
other investors. But, this is common among many different
Fund-of-funds advisors are not on the front line so to speak
investor classes. Hedge funds generally match long invest-
and do not have as much information to adjust positions as do
ments with short investments and leverage the lower risk
the multi-strategy managers. Moreover, a large portfolio pro-
portfolio to achieve returns and risk levels demanded by their
vides efficiencies over a large portfolio constructed from
investors. Mutual funds and other investors will most likely
many smaller hedge funds. The smaller hedge funds may not
move to similar mechanisms. Currently, however, they tend to
have first call for intermediation services, might not be able to
marry alpha risks with systematic exposures, market risks
attract the same level of talent, do not have the infrastructure
common to all securities, so-called ‘beta’ risk. Hedge funds
- including models, technology, and back-office services - and
separate these two risks. Some hedge funds predict these sys-
cannot secure the necessary financing lines available from the
tematic exposures, for example, whether stocks will outper-
broker-dealer network to conduct business as efficiently as
form bonds, or the Euro will depreciate against the dollar.
the larger multi-strategy funds. There are economies of scale
Most of these alpha or beta strategies are zero-sum in that
and scope. On the other hand, the fund-of-fund advisors can
some investors gain at the expense of others. In certain
pick the best talent available from the set of available hedge
instances, governments provide hedge funds with non-zero-
funds. The multi-strategy funds are unlikely to have gathered
sum gains because they are willing to subsidize hedge funds
the best talent available in all strategies. And, as psychologists
to foster other outcomes, such as supporting their currencies
claim, most organizations function better in complex environ-
or holding down interest rates to resist market forces.
ments when there is a separation of the decision makers from
the information gatherers. The information gatherers become
As mentioned previously, hedge funds provide intermediation
too involved with their own activities to make the best strate-
services. They provide liquidity to the market and risk-transfer
gic decisions. The fund-of-fund advisors play an important
services. These are not zero-sum in that the demanders of
role here in making appropriate allocation decisions.
these services know that they are giving up return, but do so
to manage their risk or to buy insurance. Liquidity providers,
such as hedge funds or private equity funds, earn returns by
9
providing liquidity to the markets. Liquidity is the price of
service providers have not survived, were absorbed within
immediacy, the cost of converting an asset into cash in a short
other firms, or have failed to create vehicles to transform
period of time. The price of liquidity does not remain constant.
themselves with the changing demands for agency or princi-
It increases as investors become pessimistic about the eco-
pal services. Institutional forms are changing continuously.
nomic outlook or at times of crisis. We observe that at times
Estimates indicate that 25% of all hedge funds close their
of crisis investors prefer to hold short-term assets and default-
doors or are absorbed each year and, in aggregate the num-
free interest rate curves become steeper. Investors prefer to
ber of hedge funds and assets under management continues
hold government bonds, causing credit spreads to widen,
to grow.
volatility to increase in all markets, and equity and asset prices
to fall. Hedge funds play an important role in providing liquid-
While many hedge funds fail because of operational failings,
ity to markets. Although they are paid for providing this serv-
and these are the most visible because they might reach the
ice, their risk-management systems must provide for sufficient
pages of the Financial Times, most fail because they either can
capital to sustain their positions.
not raise sufficient capital to sustain the cost of the operation
or they suffer performance losses of sufficient size that it is
Risk transfer differs from liquidity provision in that investors
not economic to maintain the fund. Most funds have so called
are willing to pay for the former in very liquid markets. The
‘high-water marks,’ wherein they can not charge an incentive
provider of risk transfer services is called a speculator, willing
fee until the fund performance exceeds the previous high for
to take on excess risks and transfer them to the future until
the fund’s net asset value. Therefore, with a loss, managers
other market participants are willing to secure them. Hedgers
might have no incentive to stay on to recover investor capital.
are willing to pay speculators to assume risks because for
Essentially, the high water mark is too high to overcome. In
them it is cheaper than alternative risk-reduction techniques.
any business there are operational failures. This is also the
Hedge funds provide risk transfer services to the broker/deal-
case in the hedge fund world. Funds fail because their risk
er community and other entities similar in concept to a rein-
management systems are inadequate or because they hold
surance company that provides risk transfer services for
complex securities that are hard to value. And, they value
insurance companies. Reinsurance companies carry risks for-
securities to favor good performance, which works until it fails
ward in time; insurance companies service client needs.
and a string of losses causes the scheme to unravel. But,
industry participants learn from these miscues and correct
Hedge funds are young organizations. Time will tell whether
the failures. There will always be operational failures in any
they survive and what form they will ultimately take. With a
industry. Survivorship, however, is the proof of a value-added
change in the nature of the investor base, financial entities
activity.
might again compete with hedge funds and provide market
10 - The
services more efficiently than are currently provided in the
Quantitative models fail, human intuition fails. Models assist
market. Most hedge funds are organized as ‘hunter’ groups
intuition and conversely intuition facilitates the evolution of
that will not survive for many generations. That is, few have
models. Without models hedge funds could not provide serv-
figured out how to build a business or a ‘farm’ to create an
ices. Models need to grow and evolve or they will become
enterprise that has franchise value, where the whole is greater
obsolete. However, without qualitative overlays to models;
than the sum of the parts and where knowledge and know how
that is, a combination of models and fundamental analysis,
belong to not only one or two individuals but the organization
hedge funds can not survive unless they frequently change
as a whole. Moreover, hedge fund services are complex and
their models to adapt to changing circumstances. The models
dynamic. Complexity creates a need to adapt. Myriad financial
hedge funds and financial institutions use to manage risk are
still in their infancy. The next decade will produce a revolution
in how risk is measured and controlled. The components that
must evolve include such diverse issues as how to aggregate
risks, how to optimize holdings, how to plan for shocks, how to
create a feedback system to learn from outcomes, how to provide information to superiors and investors, in effect, how to
define transparency, how to build an appropriate capital structure given the dynamics of the asset mix, and how to compensate employees to mitigate risks.
The future for hedge fund investing is exciting, dynamic, and
challenging. But, that is so for all forms of financial intermediation.
11
Risks
Size vs. performance in the hedge fund industry
Crisis management for the financial services industry
Should you, would you, could you invest in hedge funds?
Shadow accounting: The evolving practice of exercising
due diligence in fund reporting
Size vs. performance in the hedge
fund industry
James R. Hedges, IV, President and Chief Investment Officer,
LJH Global Investments
Through the years, the number of global hedge fund mana-
ured in terms of assets, staff size, and years in business.
gers has increased overall. However, the ratio of hedge fund
During the three-year period between 1999 and 2001, LJH
starts ups to closings continues to generate concerns over
confirmed that size distribution remained fairly constant with
basic issues related to back office operations, transparency,
slightly more than half of all hedge funds smaller than U.S.$
capacity, and style drift. In this study, I present the findings of
25 million, approximately 80 percent of hedge funds smaller
a size versus performance study of the hedge fund industry to
than U.S.$ 100 million, and 5 percent of all hedge funds larger
determine the extent to which operational issues affect the
than U.S.$ 500 million (Figure 1). Although many investors do
industry’s growth and the resulting impact on investors.
not consider investing with firms smaller than U.S.$ 50 million,
the data supports the view that these are indeed strong per-
Introduction to the size versus performance study
forming funds.
Investors have witnessed near exponential growth in the alternative investments industry in the last decade, with studies
According to the 2002 Putnam-Lovell paper on the possible
citing some 6,000 hedge funds with U.S.$ 1 trillion in assets,
institutionalization of hedge funds, statistical observation
up from U.S.$ 50 billion in 1990. As a result, the number of
suggests the distribution of hedge funds by size continues to
hedge fund managers is up from approximately 1,000 in the
trend downward slightly, reporting that the average hedge
late 1990s to more than 6,000 in 2003, which makes it
fund size is U.S.$ 87 million with a median base of U.S.$22 mil-
increasingly important to rely on rigorous due diligence when
lion. The implications of this might be an increase in niche
selecting the best performing managers within the various
opportunities and new strategies, as well as a possible change
investment styles and strategies.
in allocation policy to smaller, more nimble managers.
While the number of managers has grown overall, the ratio of
35
hedge fund starts ups to closings within the hedge fund indus-
30
operations, transparency, capacity, and style drift. While
approximately 700-800 hedge funds closed in 2002, another
800-900 new firms began operations. To what extent do operational issues related to growth and size stunt the industry’s
No. of funds (%)
try generates concerns over basic issues related to back office
25
20
15
10
growth? And, if that is the case, then how does this affect
investors?
5
0
Our interest in examining whether portfolio size is linked to
diminishing returns has evolved from observations of top
hedge fund managers in large funds, such as Tiger and Soros,
who left to start successful hedge funds that closed to new
<5M
5-25M
25-100M
100-500M
>500M
Size bucket (U.S.$m)
■ 1999 ■ 2000 ■ 2001
Figure 1: Size distribution of hedge funds
Source: Van Hedge Fund Advisors
investment at U.S.$ 500 million or U.S.$ 1 billion, which is far
smaller than the funds where they began their careers. At its
peak, Tiger had reached U.S.$ 22 billion, and Soros had
Advantages and disadvantages of a large asset base
reached U.S.$ 23 billion.
Advantages of a large asset base include more resources for
research, increased ability to attract and retain investment
14 - The
As background, consider that as a group, hedge funds are rela-
talent, increased efficiency in brokerage, better access to com-
tively smaller than their financial counterparts when meas-
panies, and greater bargaining power with broker/dealers.
However, challenges remain as to how to find alpha and iden-
assets under management continuously available for the time
tify the next generation of stars, which is a vital concern due
period of January 1995 through December 2002. Realizing
to the fact that larger hedge funds also have significant dis-
that many past hedge fund studies have traditionally been
advantages. Liquidity costs, for example, are significant and
incomplete, inaccurate, and prone to suffer from a number of
smaller funds are able to put all of their money into their best
biases, the research team focused on a small-sample size with
ideas. Getting in and out of trades can be more difficult for the
the characteristics of a stratified sample from within the
larger funds, especially with respect to their reduced ability to
hedge fund universe. The sample included both funds that
short. To compensate, sub-optimal investment tactics may
stopped reporting and funds that started operation during the
have to be adopted. Slippage may also occur with large orders.
same period, which ranged from January 1995 – December 2001.
Also worth noting are the psychological fears and career risks
With the goal of determining whether smaller funds outper-
that can emerge as funds grow. Managers may test their limits
formed larger funds, we measured three size-mimicking
by continuing to take in new money and increase their level of
portfolios of equally weighted, monthly returns. We classified
risk in an effort to boost returns. However, this may lead to
funds based on assets under management into three buckets,
growing concern over reputational risk, including possible dis-
small (less than or equal to U.S.$ 50 million), medium (U.S.$
missal or bankruptcy if the fund suffers. Organizational disec-
50 million – U.S.$ 150 million), or large (more than U.S.$ 150
onomies are also evident. Managing money is different than
million).
managing people and managing a business, and the quality of
Because assets under management are usually updated at
personnel is difficult to maintain as fund size grows.
year-end, the study measured performance beginning in
Methodology
January and then repeated the measurement each January
Our study reviewed verifiable, ‘clean’ data from 268 hedge
thereafter for the duration of the study. Managers that
funds in six strategies, each of which had monthly returns and
entered the database during the year were allocated to one of
Mean (t stat) St. Dev.
Skewness Kurtosis Jarque-Bera # of Funds
Mean (t stat) St. Dev.
Skewness Kurtosis Jarque-Bera # of Funds
Convertible Arbitrage
Long/Short Equity
2.27
(6.73)
3.08
0.48
0.45
3.98
1.61
(10.27)
1.44
0.93
5.13
104.29
Medium
1.19
(3.67)
2.97
0.48
3.80
53.90
1.04
(10.44) 0.91
-1.23
3.25
58.58
Large
1.39
(3.71)
3.44
-0.18
2.45
21.54
1.06
(9.99)
0.97
-1.95
6.88
219.26
All
1.77
(5.48)
2.97
0.38
0.99
5.48
1.39
(11.51)
1.10
-0.39
3.33
40.88
Small
60
Small
1.10
(10.02) 1.01
0.20
0.57
1.69
0.89 (9.64)
0.84
-1.30
4.43
92.43
102.35
0.65 (4.25)
1.40
-0.26
0.29
1.28
0.52
(4.04)
1.19
-1.58
4.39
Large
0.42
(2.55)
1.51
-1.03
4.41
83.26
0.92
(5.32)
1.59
1.04
7.93
235.55
All
0.91
(9.36)
0.89
-0.12
0.11
0.25
0.79
(8.28)
0.88
-2.06
8.02
284.87
171.57
Medium
54
44
Distressed
Global Macro
1.16
(4.39)
2.43
0.12
-0.10
0.25
1.16
(6.25)
1.70
-1.10
6.64
Medium
1.00
(3.92)
2.33
0.41
0.46
3.07
1.04
(6.12)
1.56
-0.18
2.95
31.02
Large
1.98
(4.26)
4.27
0.09
0.51
1.03
0.73
(3.96)
1.69
-3.23
18.28
1315.55
All
1.23
(4.83)
2.34
0.31
0.01
1.37
1.08
(6.64)
1.49
-1.76
8.27
282.94
Small
30
Fixed Income
Market Neutral
51
29
Figure 2: Impact of size on performance
15
three portfolios based on initial assets under management,
and the portfolio was rebalanced accordingly. ‘Dead’ funds
Small
Medium
Large
remained in the portfolio until the month of their last report-
1 Yr. Mortality Rate
3.48%
3.79%
2.03%
ing, at which time the portfolio was rebalanced to account for
8.45%
10.19%
2.78%
their exit.
11.81%
20.38%
2.86%
18.93%
34.47%
3.57%
Data analysis
23.69%
38.65%
3.57%
Figure 2 provides the results that emerged when the sample
27.22%
53.00%
3.57%
of funds was allocated to three portfolios by size and results.
32.00%
66.00%
3.57%
The evidence is clear:
Size does impact performance
Figure 4: Medium funds suffer a midlife crisis
The emerging pattern, as shown in Figures 3 and 4, clearly
proved their ability to sustain performance regardless of size.
supports the premise that smaller funds outperform larger
These managers trade in different markets, maintain minimal
funds. Thus, the conclusion that size erodes returns.
infrastructure, and benefit from economies of scale.
Global macro has been in the spotlight recently as the changing
1.5
Monthly Alphas
pace of the global economies has led to traditional investors’
having a hard time coping with the correlation, or lack there-
1
of, between the different markets across the world. In theory,
global macro managers have the resources and skills to use
0.5
sophisticated strategies to encompass all and profit from global
trends, while traditional managers have limits on the style and
0
Small funds -$50m<
Medium funds -$150m<
Large funds -$150m>
scope of their investments.
■ Long/Short ■ Market Neutral ■ Global Macro ■ Conv. Arb/ ■ Fixed Inc. ■ Distressed
We also evaluated results on a risk-adjusted basis and found
Figure 3: Size erodes performance
that Sharpe ratios remained the same, as shown in Figure 5.
Convertible arbitrage, an often-used hedge fund strategy that
However, the study also showed that mid-sized funds per-
utilizes convertible securities as part of a diversified alterna-
formed the worst, which suggests the concept of ‘mid life crisis’
tive investment portfolio, also proved to be an exception to
for hedge fund managers. While smaller funds tend to out-
these findings as smaller funds continued to show the same
source certain functions to presumably leading service
relative level of volatility as larger funds.
providers and larger, institutionalized firms have top tier
processes, mid-size firms tend to be in limbo in terms of the
As background, consider that in its most basic form, arbitrage
opportunities and processes required to attain optimum per-
entails purchasing a convertible security and selling short the
formance.
underlying stock to create a market neutral position. Returns
can be broken down into static and dynamic. Static return is
16 - The
Interesting to note is the fact that global macro managers
generated by the receipt of a coupon or dividend in addition to
proved to be the exception to the rule in this study as they
the rebate on the short selling of the underlying stock, less
Unhedge
Avg. SR
Beta Hedged Hedged
Beta/Sum
3 Factor
3 Factor/Sum
Beta
Unhedge
Avg. SR
0.77
0.66
0.83
0.81
Long/Short Equity
Beta Hedged Hedged
Beta/Sum
3 Factor
3 Factor/Sum
Beta
0.52
0.87
0.55
0.42
Small
0.60
Medium
0.26
0.17
0.07
0.21
0.06
0.69
0.67
0.43
0.67
Large
0.28
0.19
0.11
0.30
0.20
0.67
0.66
0.42
0.62
0.37
All
0.46
0.43
0.31
0.62
0.42
0.88
0.87
0.54
0.89
0.54
0.45
0.60
0.53
Fixed Income
Market Neutral
0.68
0.68
0.61
0.64
0.56
0.56
0.53
0.47
0.52
Medium
0.17
0.13
0.16
0.04
0.06
0.09
0.04
-0.03
0.00
-0.08
Large
0.01
0.02
0.05
0.00
0.03
0.32
0.27
0.15
0.24
0.12
All
0.56
0.55
0.53
0.48
0.46
0.44
0.39
0.25
0.36
0.21
Small
Distressed
Global Macro
Small
0.31
0.24
0.18
0.30
0.23
0.44
0.38
0.27
0.37
0.27
Medium
0.25
0.16
0.12
0.16
0.11
0.40
0.34
0.22
0.41
0.28
Large
0.37
0.32
0.27
0.35
0.28
0.19
0.12
0.04
0.06
-0.02
All
0.35
0.29
0.23
0.34
0.26
0.45
0.39
0.25
0.42
0.26
Figure 5: Sharpe Ratio Data
any financing costs. The dynamic portion of the return is
all of their money into their best ideas, yet larger, more senior
achieved when the arbitrageur dynamically hedges the posi-
funds often find it difficult to put continued inflows to work
tion by buying or selling more or less of the underlying stock.
due to the constraints of internal asset allocation guidelines
Dynamic returns have comprised the largest portion of a con-
and policies. With a fixed number of managers in place, putting
vertible arbitrageur’s performance in the last several years
a few more billion dollars to work might interfere with internal
and this has certainly been the case more recently, in light of
allocation infrastructure. This, in turn, can lead to creation of
the high number of low coupon paying convertibles coming to
a special fund that specializes in emerging managers, and may
market. However, the level of market volatility has been high,
require a more in-depth, analytical due diligence process guid-
providing arbitrageurs with the opportunity to capture addi-
ed by a senior analyst and risk officer capable of making a
tional returns by altering the position’s hedge ratio.
‘judgment call.’ Ongoing due diligence is also critical for a portfolio of smaller, emerging hedge funds, and the implications
Estimates of volatility could be afflicted by the problem of
for portfolio construction are obvious. Modeling portfolios to
‘stale prices’ that could be more severe with smaller funds
ensure proper diversification among strategies and managers
than with larger ones.
is critical. Results of this study support the need to evaluate
funds of all sizes when making hedge fund allocations.
Implications
In conclusion, the study’s implication is that manager selection should be biased towards those that are nimble and
responsive, and which generate alpha. Smaller funds can put
1
Voetnoten voetnoten voetnoten voetnoten voetnoten voetnoten voetnoten
voetnoten voetnoten voetnoten
17
Crisis management for the
financial services industry
Charlotte Luer, President, LJH Financial Marketing Strategies
Samuel Wang, Global Head of Marketing and PR, Capco
2003 was a scandalous year for Wall Street. Recent headline
The ‘it cannot happen to me’ response is typical, yet if compa-
stories of executive misconduct, market timing, poor corpo-
nies actually sat down and identified possible crisis scenarios
rate governance, and controversy over soft dollar payments
they would likely find it to be quite lengthy. The typical 911 calls
did little to improve the reputation of the financial services
we receive for our LJH-Capco Crisis Management program are
industry. While investors yanked more than U.S.$ 7 billion out
preventable with advance planning; making a list of the possi-
of mutual funds, some expressed concerns about whether
ble crises that have the potential to impact a business is
there would be hedge fund blow-ups involving top names in
typically enough to get companies thinking about the need to
the alternative investment industry. While the likelihood of this
have a crisis plan in place.
occurrence is slim, we do believe that if such a scenario was to
take effect many of the names implicated in current scandals
Analyze worst case scenarios
will need to be better prepared for the possible public relations
By definition, a crisis is defined as a situation that requires
crisis that such an event might bring.
immediate and coordinated action and/or will have a significant impact on the operation or reputation of the company, its
There is no doubt that Janus Capital would have benefited
affiliates, and investors. Before determining how a company
from a crystal ball to foresee payments of U.S.$ 31.5 million to
would prevent and manage a crisis the critical events must be
customers following its implication in the mutual fund market
outlined. Those who know your organization best should be
timing scandals, and that hedge fund manager Clinton Group
queried about where the greatest risks lie, what exactly could
wished it still had the U.S.$ 1.2 billion in redemptions that fol-
happen, how likely various scenarios are to occur, and what
lowed questions over valuation practices. Clearly, the time to
industry-wide issues could affect the business. Areas of vul-
get ready for a worst case scenario is before the bottom falls
nerability include:
out, yet that lesson has been learned the hard way by today’s
scandal-ridden financial services industry.
■ Employee issues such as layoffs, turnover,
Although 2003 should serve as a wake-up call, the unfortu-
■ Information and IT loss.
nate reality is that change will be slow to come in the area of
■ Fund accounting issues related to valuation,
departures of key executives.
crisis management. These days, particularly for smaller firms,
poor performance, and blow ups.
lean resources and staff dictate total focus on the next day’s
■ Regulatory probes.
goals rather than crisis preparedness. Even large institutions
■ Negative media, industry, or investor coverage
have had great difficulty weathering surprise crises initiated
or sentiment.
by the unscrupulous activities of so-called ‘star analysts.’
Despite the scandals, we predict that few organizations will
Those who think their company has a golden business model
take the time to prepare a crisis management plan and will
that is immune to crises should think again. A great brand can
instead be faced with damage control should an event occur.
be dragged into a crisis through a company with which they
Studies show that 43% of businesses suffering from a busi-
are associated through a joint venture or other type of work-
ness disaster, defined as the inability to provide customers
ing relationship. Brands established by or associated with a
with the minimum level of service they need and expect, never
high profile executive can be resilient in good times but, con-
recover sufficiently to resume business. Of those that do
versely, at great risk should the executive be dragged into a
reopen, only 29% will still be operating two years later
crisis. The mutual fund industry is one recent example of how
(www.bernstein.com ‘Crisis Manager’).
businesses can be raked over the coals just by being part of
the industry.
18 - The
We also advise clients to determine the likely impact of each
direct research of key audiences to assess perceptions is help-
potential crisis and corresponding negative ramifications prior
ful in constructing a proper crisis strategy and message.
to laying the foundation for their crisis plan. Examples of
potential problems are:
Identify key audiences
Additionally, identify and analyze key audiences that could be
■ Loss of credibility with clients, affiliates, media, employees,
and other important audiences.
affected by the crisis, including employees, clients, suppliers,
regulators, analysts, special industry groups, and others. This
■ Regulatory scrutiny.
list is probably lengthier than you might expect and might
■ Loss of business, clients, and assets.
prove to be beneficial in further determining the extent of
■ The need to regain control of clients, media, regulators,
your crisis program.
management costs, and regulatory damage.
■ Redevelopment of business model, brand,
corporate/product name, or infrastructure changes.
Select channels of communications
Outline each of the ways you plan to communicate with these
audiences, remembering that the medium is as important as
Put your team in place
the message. The ‘do unto others as you would have others do
A first step in modeling the crisis management plan is desig-
unto you’ saying is applicable in this situation. Think about
nating a crisis control officer who will be the spokesperson at
how you would want to receive bad news if you were an
the scene and on the front line. A strong leadership presence
employee or investor, for example, and design the communi-
with the ability to portray honesty, calm, and confidence are a
cation strategy with that in mind. Communications will likely
must. All calls should be referred to this person. Secondly,
require a combination of tools.
determine the key members of the crisis team, including individuals within the organization, and assess whether you have
Prepare the response tools
in place or need to enlist outside representatives such as an
The next step is to generate the response tools required in the
attorney (potentially all crises), a lobbyist (regulatory crisis),
event of a crisis. Most organizations develop a crisis commu-
and a media strategist (reputation crisis). When outlining the
nications plan as a subset of the larger crisis management
various courses of responsiveness, specific duties need to be
plan. The crisis communications plan should outline the goals
assigned to each team member. Once a centralized plan is in
of the effort and serve as a flexible guide. Among the activi-
place for various worst case scenarios, training may be need-
ties that could be applicable in various crisis scenarios are:
ed to insure that everyone is well prepared to respond appropriately. Hold daily morning team calls to coordinate messages
that will be delivered to employees, media, and key customers.
Involving management at all levels will help ensure success.
■ Briefings for key audiences conducted either in person
or via teleconference.
■ News releases.
■ Newsletter coverage.
Agree on crisis strategy and goals
Once the crisis team is operational, members should agree on
■ Internet websites – special designated section on
the organization’s or a separate site.
what specific goals the crisis plan is designed to thwart, and
■ Open houses or other events.
how the crisis can be mitigated so it does not encroach on
■ Video presentations or web casts.
business goals. Have competitors taken advantage to paint an
■ White papers and/or byline articles.
inaccurate perception of your firm? Has investor or employee
■ E-mail messages to key constituents.
confidence taken a hit? Dependant on time and resources,
■ Specially produced collateral, brochures, displays, or exhibits.
19
■ Newspaper advertisements.
■ Broadcast media interviews by the CEO.
■ Editorial meetings.
■ Toll free crisis hotline.
Once the crisis plan is in place, it needs to be monitored on a
regular basis. Ideally, the plan should be reviewed once a
quarter by the head of the crisis team and outside counsel.
Monitoring it closely to be sure it remains up-to-date and correctly reflects your business structure and environment will
ensure that it reflects the evolution of the market and changes
to your business model.
Conclusion
Clearly, the events of 2003 have taught the financial services
industry not to take the crisis preparedness and reputation
management process for granted or underestimate its importance. The best crisis management is really crisis prevention,
which necessitates a clear understanding of worst case scenarios that could result from corporate actions. Once these
scenarios have been outlined, there is no substitute for having
a strong plan in place that serves as a pillar for the broader
business strategy and is continuously monitored and communicated to all constituencies. That said, with crisis comes
opportunity. It is not too late to prepare and that has never
been more apparent than now for the financial services
industry.
20 - The
21
Risks
The role of
hedge funds for
long-term investors
John M. Mulvey
Professor, Bendheim Center for Finance,
Princeton University
Abstract
Hedge funds have gained popularity for increasing investment
returns. We focus on the role of this asset category for longterm investors, with attention to rebalancing a portfolio of
diversified assets. An investor must seek out securities with
low correlations to traditional assets to maximize asset
growth. Current hedge fund returns, as measured by average
performance, show dependencies with equity returns. Other
limitations and opportunities for hedge funds are discussed.
23
The promise
Hedge funds are defined by the generic description – ‘any
should take into account their goals and liabilities within an
pooled investment vehicle that is privately organized, admin-
asset and liability study [Ziemba and Mulvey (1998]. To this
istered by professional investment managers, and not widely
point, a pension plan will determine its surplus by computing
available to the public’ [IMF (2000)]. The hedge fund industry
the market value (assets) – market value (liabilities). Hedge
has grown from roughly U.S.$ 100 billion market value in 1990
funds may fit within a carefully crafted asset-liability system,
to approximately U.S.$ 750 billion in early 2004. Almost 6000
but this question lies outside the present discussion.
funds are now available. There are several underlying causes
for this growth:
We will focus on long-term investors who possess a moderateto-aggressive tolerance for risk. Their goal, and our goal in this
■ Institutions and individuals are under severe pressure to
report, is to maximize the growth of assets over a substantial
generate high returns in order to meet future liabilities and
time period, while maintaining risks within a specified limit1.
goals, including under-funded U.S. pension plans, university
Naturally, the investment horizon depends upon circum-
endowments, and state retirement accounts.
stances - a family trust or pension plan, for example, may set
■ Prominent U.S. institutional investors, such as Harvard,
seven to ten years as a sensible planning horizon.
Princeton, and Yale Universities, have achieved superior
returns by committing substantial portions of their capital
The reality
to alternative investments, including hedge funds,
Several barriers must be overcome in order to successfully
in concert with deploying leverage.
invest in hedge funds. First, despite recent improvements,
■ Traditional assets have performed below expectations over
there are severe informational constraints on reported per-
the past few years (notwithstanding the recent rise in
formance. The historical record, largely, began around 1990
equities).
when the hedge fund universe was much smaller and less well
■ Venture capital investments have wilted during the
recent past.
■ Hedge funds have held up reasonably well. The average
established. Not all hedge funds are open regarding their
results due to proprietary and related considerations.
Likewise, it is difficult to estimate the survivor bias, since
returns for many hedge fund sectors have been noteworthy
hedge funds may stop reporting results when anticipating a
(see below).
meltdown. Studies have estimated the bias at 1.5 % to 3 % or
■ Current academic research supports the supposition that
more per year. Also, most hedge funds are relatively small -
patterns in returns may be detected by careful analysis
under U.S.$ 100 million in capital – thereby inaccessible for
(e.g. market micro-structures).
many institutional investors.
■ Successful hedge fund managers have achieved notoriety
by their proprietary approach to trading and, on occasion,
Second, management costs are higher than traditional mutual
eye-popping returns.
funds. This headwind is partially offset by incentive fees that
pay a bonus only when the fund achieves results above a
Should investors put a serious amount of capital into this cate-
designated benchmark. Thus, the goals of the investor and
gory? Is the game too late? How can the reader make deci-
manager are closely aligned.
sions about investing in hedge funds? We will discuss these
issues in this article.
A third issue involves the ability of an investor to rebalance his
portfolio on a regular basis. Hedge funds require lock up periods
Due to their inflexible structure, short-term investors should
and other restrictions; it may be difficult to add or subtract
mostly avoid hedge funds. Likewise, conservative investors
money as conditions warrant. This restriction is particularly
1
24 - The
For example, the volatility of a target mix such as 70% equity - 30% bonds is
reasonable as a start.
constraining on large institutional investors. We will take up
FOFs have achieved good results over the historical period, as
the rebalancing issue below.
compared with traditional assets, and as measured by the
mean return of reporting funds. We are assuming zero sur-
Next, to evaluate a portfolio on an anticipatory basis, we must
vivor bias in these discussions; the reader should carefully fac-
be able to estimate the factors that drive returns. In certain
tor this issue into future projections, however.
cases, the issue is straightforward. For example, funds in the
statistical arbitrage category generate returns that are rela-
The annual returns and volatilities of asset categories for the
tively uncorrelated with economic factors. This independence
past 13 years (January 1990 to August 2003) are shown below
is, in fact, a prime advantage of a hedge fund. But, in other
and plotted in Figure 1.
cases, estimating future returns is complicated by the hedge
fund manager’s freedom to change direction abruptly. A fund
Table 1
may be 150% long and 50% short in one period, and the
Geo returns
Std (returns)
12.0 %
opposite in the next period. It is difficult to construct a reliable
portfolio system under these changing conditions since we
Real Estate Trusts (REIT)
10.7 %
must somehow estimate the manager’s decision processes.
S&P500
10.1 %
14.5 %
Fund of Funds
9.6%
4.4 %
In addition, certain strategies will produce consistent winners
U.S. T-bonds
9.1 %
8.5 %
within a rather narrow size limit – e.g. index arbitrage. When a
U.S. T-bills
5.3 %
0.9 %
large number of well-placed investors work in an area, the
International Equity (EAFE)
2.0 %
17.4 %
large excess returns that initially characterized the area will
fall to a more modest level. Again, it is difficult to reliably estimate this relationship within an anticipatory framework.
The FOF performance is slightly below the S&P500 index with
a much lower volatility. This performance is consistent with
A partial solution – fund-of-funds
the mean returns for sub-sectors in the hedge fund universe
A funds-of-funds (FOFs) is an entity that invests in a narrow or
achieving the following results [Dow Jones & Co. (2004)]:
more commonly a broad segment of the hedge fund universe.
The FOF conducts the time consuming task of due diligence
for the clients and produces a diversified portfolio of individ-
Table 2
ual hedge fund managers. Thus, the implosion of any single
Geo return
Std (returns) Corr.S&P500
fund will cause a minor or temporary distortion to the overall
portfolio.
Event driven
11.9 %
4.5 %
.487
Global emerging
13.0 %
15.7 %
.493
In several ways, the FOF performs a service that is similar to a
Global international 11.4 %
6.9 %
.51
mutual fund by selecting individual fund managers (as com-
Global established
14.5 %
9.0 %
.763
pared with stock selection). This service is particularly helpful
Global macro
12.9 %
6.7 %
.43
for investors who are unable to spend adequate time or
Market neutral
10.6 %
1.5 %
.323
resources on the selection tasks. Of course, the investor must
pay for the help, thus reducing benefits, and the fund-of-fund
must be chosen from a number of providers.
25
But again, we warn readers that this data does not adjust for
returns are quite good on a standalone basis – showing 9.56%
survivor bias or the size effect mentioned earlier. Schneeweis,
returns, and 4.4% volatility. The blended portfolio achieves a
Kazemi, and Martin (2001) discuss this hedge fund sub-sector
solid return equal to 10.5%, and 8.0% volatility.
performance.
However, a similar pattern can be achieved by replacing the
Evaluating historical performance within
a portfolio context
FOF with T-Bonds, giving a blend with – S&P500, REITs, and T-
Any serious asset allocation study for a long-term investor,
stand-alone basis, the T-Bond volatility works to the advantage
such as a pension plan or family trust, begins with reviewing
of the long-term investor. Rebalancing gains are higher when
historical performance. We all know, of course, that historical
an asset has higher volatility and good expected returns
results are no guarantee of future returns. But there are
[Mulvey, Lu, and Sweemer (2001); Mulvey, Pauling, and Madey
important lessons to be learned.
(2002)].
Unfortunately, reliable data on hedge funds is unavailable
Additionally, two practical issues arise when placing FOFs with-
before 1990. Thus, we must be particularly careful when eval-
in a blended portfolio. First, institutional constraints with
uating this data for long-term projections. Also, as mentioned,
hedge funds2 prevent much of the monthly rebalancing. If fact,
several issues complicate the task – including survivor bias
FOF’s low volatility reduces rebalancing gains even if the
and size limits. But to start, we turn to Figure 1. Here, returns
transactional constraints are dropped. Second, of course, his-
and risks are shown for the six aforementioned assets over
torical returns may not be accessible for future investors.
Bonds (point ABC). Even though, FOFs dominate T-Bonds on a
the period 1990 to 2003.
What to expect and recommendations
First, observe the three U.S. assets - equity (S&P500), govern-
Hedge funds are likely to continue growing in popularity, due
ment bonds (T-Bonds), and CASH (T-Bills) display the tradi-
to the increased demand for customized products by institu-
tional lineup - from conservative with low returns to more
tional investors, wealthy individuals, and family trusts. And the
aggressive with higher returns; see the drawn efficient fron-
large potential fee structure will attract entrepreneurial asset
tier. Below this line are two assets - EAFE and GSCI - due to the
managers. Given this trend, we expect that the area will
abysmal return of Japanese equities and the gradual decline
receive greater attention from investors and researchers alike.
in interest rates, inflation, and commodity prices since 1990.
Above the line are the superior assets (from the 13-year per-
Surprisingly, perhaps, novel investment opportunities have
spective) – real estate investment trusts (REITs) and FOFs.
become accessible for individuals with modest means. Take
the case of exchange traded funds and single stock futures.
To calculate the best combination, we could solve an optimal
We are seeing a split between inexpensive standardized prod-
portfolio problem as is commonly done. But our purposes are
ucts, and the high-cost, high potential value-added services
more modest. We focus on two simple portfolios as equal-
such as hedge funds. This pattern is evident in other domains
weighted combinations of three assets. We call these blended
such as retail merchandise – Wal-Mart and Sam’s Club on the
portfolios. To achieve a blended portfolio, the investor rebal-
one hand, and expensive food-stores such as Wegman’s that
ances his assets at the beginning of each month to the desired
supply superior service and customized prepared foods, on
ratio. Each asset begins the month at one-third of the
the other hand (often in the same shopping center). Our rec-
investor’s wealth. Two sets of blended assets are noteworthy.
ommendations are as follows. While hedge funds data exists
First, we combine S&P500, REITs, FOFs (point ABD). The FOF
since 1990, these funds have not been fully battle tested.
2 Such as lock up periods.
26 - The
Risk-Return Profile of Rebalanced Portfolios
(monthly returns from January 1990 - August 2003)
14.00%
ABD - 50% Leverage
ABC - 50% Leverage
12.00%
Compound Annual Return
ABD
10.00%
B (REIT)
ABC
A (S&P 500)
D (Fund of Funds)
C (T-Bond)
8.00%
GSCI
6.00%
T-Bill
4.00%
Single Assets Portfolios
Rebalanced Portfolios w/o Fund of Funds
2.00%
EAFE
Rebalanced Portfolio with Fund of Funds
0.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
Standard Deviation
Figure 1: Historical performance of selected assets (1990 to 2003)
Thus, many long-term investors should wait for the category
■ Further evidence that hedge fund returns will do well when
to become more seasoned, especially as the size of the indus-
traditional assets are performing poorly – to hedge in a
try grows, before committing a substantial percentage of
meaningful manner. The correlation of absolute return
assets. As discussed, hurdles must be overcome - lack of trans-
hedge funds with the S&P500 should be close to zero.
parency, difficulty to pick the better funds (too much survivor
bias and extra costs), and for FOFs the need to generate
returns with lower correlations with market returns. Investors
may put a portion of their assets in hedge funds in order to
gain experience with this asset class. However, a large commitment is risky at present for novice hedge fund investors.
■ Greater flexibility to move money into and out of this
category as conditions warrant (strive for re-balancing gains).
■ Some reduction in fees if investor stays with a fund for a
longer time period and the manager is relatively successful.
■ Greater reliance on multi-strategy funds that take
advantage of opportunities across hedge fund tactics.
There are several items that would assist in generating
In conclusion, as with all new technologies, the early imple-
increased interest in hedge funds from long-term investors
menters take on increased risks. But indeed opportunities
such as pension plans. These include:
exist for superior performance as seen by the results of top
U.S. University endowments.
27
A critical concept for generating superior returns for long-
Appendix
term investors is to discover novel ways to diversify their port-
A description of the sub-sectors of the CISDM/MAR database is listed below.
folio, thus reducing volatility, and then to leverage the widely-
Event driven: The investment theme is dominated by events that are seen as special situations or opportunities to capitalize from price fluctuations. They specialize either in
risk arbitrage (merger arbitrage) or distressed securities.
diversified portfolio to an acceptable risk tolerance. Harvard
University implements this concept as well as anyone [Dow
Jones & Co. (2004)]. Their portfolio consists of a wide range
of assets – timber, inflation linked bonds, hedge funds, venture
capital, etc. In this context, the primary requirement is to
generate good returns with relatively low correlation to the
other assets. To illustrate this point, see Figure 1 for leveraging
the two blended portfolios by 50% – generating mixes with
13% annual returns and 12 % volatility.
Hedge fund managers and potential/actual investors in alternative investments should take note of these complementary
goals.
References
•
•
•
•
•
•
•
28 - The
CISDM Hedge Fund Benchmark Series, Center for International Securities and
Derivative Markets, University of Massachusetts, in cooperation with MAR, 2003.
Dow Jones and Company, Barrons Online, ‘Educating Harvard,
How Two Money Managers + almost $70 Million in Pay = a Bargain,’ Feb 2, 2004.
International Monetary Fund, Background note on the Hedge Fund Industry,
prepared for the Financial Stability Forum, 2000, http://www.fsforum.org .
Mulvey, J, N. Lu, and J. Sweemer, 2001, ‘Rebalancing Strategies for Multi-period
Asset Allocation,’ Wealth Magazine, Fall
Mulvey, W. Pauling, and R. Madey, 2002, ‘Advantages of Multi-Period
Portfolio Models,’ Journal of Portfolio Management, Winter
Schneeweis, T., H. Kazemi, G. Martin, 2001, ‘Understanding Hedge Fund Performance,’
Lehman Brothers Report, November
Ziemba, W. and J. Mulvey, (editors), Worldwide Asset and Liability Modeling,
Cambridge University Press, 1998.
Global emerging: In this type of hedge funds, managers invest in less mature financial
markets. Because shorting is not permitted in many emerging markets, managers must
go to cash or other markets when valuations make being long unattractive. They focus
on specific regions.
Global international: Here, the manager pays attention to economic change around the
world (except U.S.); bottom-up-oriented in that they tend to be stock-pickers in markets
they like. They use index derivatives much less than macro managers.
Global established: They focus on opportunities in established markets. (U.S. opportunity, European opportunity, Japanese opportunity). This type of hedge funds can be sub
classified as Growth, Small-Cap, and Value Global Established.
Global macro: They are the classic opportunistic funds investing anywhere they see
value. They use leverage and derivatives to enhance positions, which will have varying
time-frames from short (less than 1 month) to long (more than 12 months).
Market neutral: They attempt to minimize market risk by using such strategies as convertible arbitrage, stock arbitrage, and fixed-income arbitrage or by taking both short
and long positions in different stocks.
Fund of funds: They are funds, which allocate capital among other investment funds,
including hedge funds. They can either be diversified, which allocate capital to a variety
of fund types or niche, which allocate capital to a specific type of fund.
29
Risks
Finding the sweet
spot of hedge fund
diversification
François-Serge Lhabitant
Member of Senior Management at Union Bancaire
Privée, and a Professor of Finance at HEC
University of Lausanne (Switzerland) and at
EDHEC Business School (France)
Michelle Learned De Piante Vicin
Analyst, Alternative Asset Advisors - 3
Abstract
Hedge funds are often thought of as being high-risk invest-
benefits, whatever the considered strategy. In addition, for
ments and many investors in the past have shied away from
some strategies, too much diversification results in undesir-
them for fear of making large losses. However, over the recent
able side effects in the higher moments of the return
years, hedge funds have generally substantially outperformed
distribution. Thus, while a fund of hedge funds may mitigate
equities, with much lower volatility. As a consequence, they
the negative effects of a hedge fund failure through diversifi-
are now in strong demand, particularly when one remembers
cation, too much diversification is also likely to result in
that any risk associated with hedge fund investing diminishes
diworsification.
in importance when the funds are repackaged into fund of
funds products.
Once one admits that portfolio diversification reduces manager risk, there is a fundamental question that needs to be
addressed, namely, the optimal number of hedge funds to
effectively benefit from diversification. In this paper, using a
large database of more than 6000 hedge funds, we provide
evidence that from a pure market risk perspective, a small
number of funds is sufficient to reap most of the diversification
31
Introduction
exposure as high as 30% to alternative investments, and insti-
What if you had invested all of your liquid net worth in Long
tutional investors confess a 2% to 5% allocation to hedge
Term Capital Management LP in 1995? What if you had looked
funds.
at Meriwether’s track record, admired his partners, understood the strategy, and verified the lines of credit? It is easy to
Since choosing a bad manager may easily wipe out all the
imagine that in 1996, you congratulated yourself for having
benefits of a hedge fund allocation, investing in only one
such an outstanding investment. And when summer of 1997
hedge fund is likely to be sub-optimal. Thus, most of the time,
rolled around, you may even have considered leveraging your
the preferred structure to enter the alternative investment
winner. But by the autumn of 1998, you would have undoubt-
arena is a fund of hedge funds. It frees the investor from the
edly been asking yourself if you had any stashes of cash safely
responsibility of monitoring individual managers and provides
tucked away in a forgotten bank account. And you would also
instant diversification within the hedge fund universe. This is,
have remembered the old adage: ‘Don’t put all your eggs in
simply stated, appealing.
one basket’.
Yet the practice of diversifying a portfolio’s hedge fund expoAlbeit intuitive to us all, Harry Markowitz (1952, 1959) wrote
sure is not as simple as it is in the traditional asset classes.
the first paper on the benefits of diversification for an investor.
Although the SEC is considering regulation of hedge funds,
Under the assumption that an investor is primarily concerned
they are only loosely regulated for the time being. This effec-
by two elements in their portfolios – risk and return –
tively means that finding the information necessary for ana-
Markowitz suggested a quadratic programming algorithm to
lyzing them so as to properly optimize a portfolio of hedge
optimize the combination of assets based on their mean rates
funds is complex, and costly. The process of selecting hedge
of return and standard deviations. The objective was the
funds for investment requires access to information that is not
aggregation of risky assets in a portfolio to minimize its over-
publicly available, an analytical process that includes a clear
all risk, according to the correlation among them. Key to this
conception of the investment strategies employed and the
process is the fact that a portfolio’s risk is less than the sum of
ensuing risks, and high minimum investments. Gaining expo-
its individual assets’ risk.
sure to the market of hedge funds so as to choose the best,
visits to analyze the business risk, and the labor-intensive
Today, virtually everyone in asset management has been
process of due diligence requires expertise and knowledge of
touched by Markowitz’s groundbreaking insights that invest-
the crowded industry. Thereafter, monitoring performance
ment returns are tied to risks. Modern Portfolio Theory has
and risk is an on-going activity. Ergo, the fund of funds busi-
transformed a sleepy industry run by bank trust departments
ness is flourishing.
and insurance companies into a dynamically changing busi-
32 - The
ness. Diversification is now well practiced among investors,
Funds of funds have expanded from private bank advisory
whether in terms of geographical exposures, asset classes, or
services to their high net worth clients, to multi-billion dollar,
sectors. But the new key to portfolio diversification seems to
institution-serving international entities, and virtually every
be elsewhere, more precisely in the advent of a new genera-
combination in between. The products span the range from
tion of alternative investments known as absolute return
off-the-shelf, multi-strategy fund of funds to concentrated,
strategies and hedge funds. Regardless of whether or not
single-strategy tailored mandates. Given the assumptions that
hedge funds truly are a separate asset class, or rather a variety
diversifying a portfolio’s asset allocation to include hedge
of risk classes, they are now an acknowledged portion in diver-
funds and diversifying the allocation to hedge funds are bene-
sified portfolios. Private banks commonly recommend an
ficial, the question of how many funds are needed to optimize
the diversification benefits is the subject of our interest in this
assets in order to maximize the benefits and minimize the
article. Funds of funds provide access to a diversified hedge
overlap. Hence, assets with high volatilities but negative cor-
fund allocation, but how many hedge funds in a single fund of
relation are good combinations in a portfolio, whereas assets
funds is optimal?
that have high volatilities and high correlation are less optimally diversified.
The art and science of diversification
Numerous papers have been written on the subject of how
In practice, most hedge fund investors apply a naïve approach
many assets are needed to reach an optimally diversified port-
to diversification, rather than the Markowitz optimization.
1
folio. A few papers have also focused on how many hedge
There are several reasons for this. Firstly, most optimizers are
funds are needed to reach an optimally diversified portfolio.
unable to effectively incorporate the operational constraints
The least we can say is that no conclusion has been reached
demanded by hedge fund investments such as: minimum
yet. On the academic side, the literature suggests that approx-
investments, lock-up periods, and redemption notifications,
imately eight to ten managers should be sufficient to reduce
etc. Secondly, the lack of quantity and quality of hedge fund
significantly the overall risk of the portfolio – see Billingsley
information limits the capacity of econometric modeling; opti-
and Chance (1996) for managed futures, Henker and Martin
mizers require precise forecasts of risks, returns, and correla-
(1998) for CTAs, and Henker (1998) for hedge funds. However,
tions, while hedge fund returns and strategies are not neces-
Amin and Kat (2002) show that one has to hold at least twenty
sarily stable over time, let alone the omnipresent difficulties of
funds to fully realize the diversification potential in hedge
predicting the future economic environment. Finally, hedge
funds. From the practitioner’s perspective, the consensus
fund return distributions are not always normal, meaning, they
seems to be that at least thirty to forty managers are neces-
tend to exhibit skewness and fat tails; mean-variance optimiz-
sary to diversify effectively, as shown by the information
ers work from an assumption of a normal distribution.
released by funds of hedge funds. The short note by Ruddick
(2002) is evidence that the maximum benefits of diversifica-
Our analysis
tion are reached with around twenty funds, and that it is still
In this study, our aim was to assess the real benefits of diver-
possible to have them with forty funds. But before going any
sification in hedge fund portfolios. To provide the most com-
further, it is worth discussing two approaches to diversifica-
prehensive representation of the hedge fund universe as pos-
tion: naïve and optimized.
sible, we aggregated and cleaned quarterly data from
Managed Account Reports, Hedge Fund Research, TASS+,
Naïve diversification refers to the ‘1/N heuristics’ method,
Altvest, and Evaluation Associates Capital Management, as
which essentially entails dividing the total allocation evenly
well as directly from several hedge fund administrators. Thus,
among the available assets. Naïve diversification gives no
our database totaled 6985 distinct hedge funds, with no
import to the relationship between assets. That is, the corre-
restriction as to their assets under management, or their lifes-
lation among the assets is not utilized in the allocation deci-
pan. It does include a large number of now defunct funds,
sion. This method of diversification does, indeed, reduce
which should diminish the survivorship bias, albeit not entirely.
volatility, and it is simple to practice when there is a lack of
knowledge about the assets and interrelationships.
With our data, we created series of equally weighted portfolios
with increasing sizes (N = 1, 2, . . . 50 funds) of randomly
By contrast, optimized diversification follows the work
selected underlying hedge funds. For each portfolio, we built a
Markowitz laid out in his dissertation in 1952. His mathemati-
time series of returns and used it to generate various statistics
cal approach takes into account the correlation between
(average return, volatility, etc.). For each portfolio size, this
1
See Elton and Gruber (1977), Evans and Archer (1968), Latane and Young (1969),
Fischer and Lorie (1970), Mokkelbost (1971), Wagner and Lau (1971), Johnson and
Shannon (1974), Lorie (1975), Upson, Jessup and Matsumoto (1975), Lloyd, Hand
and Modani, (1981), Tole (1982), Statman (1987), Newbould and Poon (1993) or
O’Neal (1997), among others.
33
process is repeated 1,000 times to obtain 1,000 observations
Diversification within styles3
of each statistic. This is necessary to estimate the typical
In general, naïve diversification of hedge funds provides bene-
behavior of a portfolio of size N. When a fund in one of our
fits to the investor; however, our study finds that a limited
sample portfolios stops reporting to the database provider
number of funds are needed to receive the maximum of
(because of liquidation or simply self removal), we have simply
potential benefits. Figure 1 shows the effect on the fund of
liquidated it at the latest available net asset value and reallo-
hedge funds portfolio’s return as the number of hedge funds
cated the assets equally among the remaining funds in the
in the portfolio changes. Not unsurprisingly, the return of the
sample portfolio.
portfolio is not greatly affected by the number of funds. This
result is not surprising, due to the linearity of the average
We tested both within-style and across-style diversification. In
operator4. Of course, the mean return diverges widely across
the within-style approach, investors create portfolios by ran-
strategies and over time.
domly selecting managers within a particular investment
style. The result is a single-strategy diversified portfolio. In the
across-style approach, investors create portfolios by randomly
selecting managers in any investment style. The result is
1
6
11
16
21
26
31
36
41
46
Number
of funds
24
22
generally a multi-strategy diversified portfolio.
20
We tested both naïve and smart diversification during three
18
distinct time periods: 1990-1993, 1994-1997, and 1998-2001. As
described in the previous section, naïve diversification is the
practice of randomly choosing a specified number of funds,
and allocating assets evenly among them. The second
16
14
12
approach, smart diversification, is only applicable to acrossstyle diversification. It also assumes that investors will
randomly choose a specified number of funds and allocate
10
8
assets evenly among them. However, the choice is made such
that no single investment style is more represented than
another. This is to say that the addition of each new fund to
the portfolio is a rotational process through the universe of
6
Return (%)
Figure 1: Evolution of the mean return of a fund of funds portfolio as a function
of the number of underlying hedge funds.
investment styles2. For example, if we classify all hedge funds
into one of ten investment styles, then the smart diversification of a ten-fund portfolio would randomly select one hedge
fund from each of the ten styles.
34
2 We used the ten generally accepted hedge fund investment styles, Global
macro, Commodity trading advisors, Long/short equity, Dedicated short bias,
Emerging markets, Equity market neutral, Event-driven, Fixed income arbitrage,
Convertible arbitrage, and Multi-strategy funds. Note that in this study, we rely on
the style classification as given by the hedge fund manager, because this is the
most likely approach a typical investor will take. However, a more accurate
classification could be made by style analysis, which tracks past performance and
exposures to map the manager’s trades. See Lhabitant (2001, 2002)
Global Macro:
Multi-strategies:
Convert. Arb.:
Fixed Income Arb.:
Long-short Equity:
Market Neutral:
Managed Futures:
Emerging:
Event Driven:
Short Sellers:
3 For the sake of clarity, we only report the results we obtained for the 1998-2001
period. The results for other periods are available from the authors.
4 The average operator is indeed linear. In a sense, the figure we obtain for a
one-fund portfolio is the average of 1,000 hedge funds returns, while the figure for
a two-fund portfolio will simply be the average of 2,000 hedge funds. The number
will therefore rapidly converge to the sample average.
Figure 2 shows the effect on the volatility of the portfolio
skewed. For this reason, we have included the effects of the
according to the number of funds. The number of funds
number of hedge funds in a portfolio on skewness and kurto-
required to reduce the volatility is quite low. We find that
sis in this study. Skewness is expected to disappear with diver-
approximately ten hedge funds are enough to reduce the
sification as funds with negative skewness are mixed with pos-
majority of volatility. Adding more funds thereafter makes
itively skewed ones so that, at the aggregate level, these indi-
only marginal gains. This result stands whatever the period
vidual effects are canceled. For the same reason, we expect
and the investment style.
excess kurtosis to be somehow reduced by diversification.
1
6
11
16
21
26
31
36
41
46
Number
of funds
30
1
6
11
16
21
26
31
36
41
46
Number
of funds
2
1
25
0
20
-1
15
-2
10
-3
5
-4
0
Volatility (%)
-5
Skewness
Figure 2: Impact of diversification on the volatility of a fund of funds portfolio
Figure 3: Impact of diversification on the skewness of a fund of funds portfolio
Global Macro:
Multi-strategies:
Global Macro:
Convert. Arb.:
Fixed Income Arb.:
Convert. Arb.:
Fixed Income Arb.:
Long-short Equity:
Market Neutral:
Long-short Equity:
Market Neutral:
Managed Futures:
Emerging:
Managed Futures:
Emerging:
Event Driven:
Short Sellers:
Event Driven:
Short Sellers:
Multi-strategies:
As mentioned previously, hedge fund returns are generally not
As Figure 3 illustrates, we find that the average skewness
normally distributed. Asymmetry and fat tails in the return dis-
tends to drop as the number of funds increases. In Figure 4,
tribution are a result of complexity of their trading styles. If a
we see less of an effect on the portfolio’s kurtosis when
fund’s returns are positively skewed, the investor is probably
increasing the number of hedge funds. But it is worth noting
quite happy. If the tails are fat, the investor can expect a more
that for fixed income arbitrage an event-driven diversification
thrilling investment ride. The characteristics of a hedge fund’s
may create problems, as skewness decreases and kurtosis
past performance do not determine the future performance,
increases sharply. Interestingly, we observe the same pattern
as all disclosure statements continuously remind us. However,
for these two strategies for the other periods considered. It is
a fund that is highly positively skewed will most certainly give
our assumption that many of these managers are largely
the investor a different gut feeling than one that is negatively
invested in the same underlying assets, and are therefore
35
1
6
11
16
21
26
31
36
41
46
Number
of funds
sequent net asset value over a period. Finally, the value at risk
25
(VaR) is an estimate of the maximum amount a particular fund
could lose over a one-month period in normal market conditions. In our case, we defined normal market conditions as
20
being 95% of the time and we calculated value at risk by simply taking the 5% percentile of the empirical return distribution over the considered period.
15
All these risk measures provided the same answer: diversifica10
tion seems to work well in terms of downside risk reduction,
but most of the diversification benefits are obtained with
about 10 funds. Adding more funds still provides benefits, but
5
the gains seem marginal compared to the drawbacks of managing the corresponding portfolio.
0
Kurtosis
Figure 4: Impact of diversification on the kurtosis of a fund of funds portfolio
1
6
11
16
21
26
31
36
41
46
Number
of funds
24
Global Macro:
Multi-strategies:
Convert. Arb.:
Fixed Income Arb.:
Long/short Equity:
Market Neutral:
Managed Futures:
Emerging:
Event Driven:
Short Sellers:
22
20
18
exposed to the same systemic risks (LTCM crisis, the AlcatelHoneywell merger failure, distressed situations that went
16
14
bankrupt such as Kmart, Global Crossing, WorldCom, and
Qwest Communications, or the planned elimination of the 30-
12
year T-Bond contract etc.). By diversifying among them, we
10
are, in a sense, sure to capture these risks.
8
We also analyzed the behavior of three commonly accepted
6
Worst monthly return (%)
downside risk statistics, the worst monthly return, the value at
risk, and the maximum drawdown. The largest monthly loss is
the greatest decline in net asset value for a particular hedge
Global Macro:
Multi-strategies:
fund for any one-month period over the period considered.
Convert. Arb.:
Fixed Income Arb.:
The maximum drawdown is the biggest percentage-losing
Long/short Equity:
Market Neutral:
Managed Futures:
Emerging:
Event Driven:
Short Sellers:
period (peak to valley) experienced by a particular fund,
regardless of whether or not the draw-down consisted of consecutive months of negative performance. It corresponds to
the loss that an investor would experience buying shares at
the highest net asset value and selling them at the lowest sub-
36 - The
Figure 5: Impact of diversification on the worst monthly return of a fund of funds portfolio
1
6
11
16
21
26
31
36
41
46
Number
of funds
1
0
0
-2
-10
-4
-20
-6
-30
-8
-40
-10
-50
-12
VaR95%,1M (%)
-60
6
11
16
21
26
31
36
41
46
Number
of funds
Max. Drawdown (%)
Figure 6: Impact of diversification on the value at risk of a fund of funds portfolio
Figure 7: Impact of diversification on the maximum drawdown of a fund of funds portfolio
Global Macro:
Multi-strategies:
Global Macro:
Multi-strategies:
Convert. Arb.:
Fixed Income Arb.:
Convert. Arb.:
Fixed Income Arb.:
Long/short Equity:
Market Neutral:
Long/short Equity:
Market Neutral:
Managed Futures:
Emerging:
Managed Futures:
Emerging:
Event Driven:
Short Sellers:
Event Driven:
Short Sellers:
Finally, the last statistic we examined was correlation. Given
Whatever the risk measure, it seems that around ten hedge
that investors generally still maintain an equity portfolio
funds are sufficient to eliminate most of the specific risk in a
alongside their hedge fund allocation, it is essential to exam-
portfolio.
ine the impact of the number of funds in a portfolio on its correlation attributes with equities (represented hereafter by the
This contradicts what we observe in the fund of hedge funds
S&P 500). As illustrated in Figure 8, it appears that diversifi-
portfolios in the current market, that is, portfolios of 30 to 50
cation within a style leads to a small increase in the absolute
hedge funds. From a pure risk reduction perspective, the
value of the correlation with the S&P 500. That is, positive cor-
diversification gains seem marginal compared to the draw-
relations with the S&P 500 tend to increase, while negative
backs of managing the corresponding portfolio (large mini-
correlations with the S&P 500 tend to decrease as the number
mum investment requirements for each fund, multiple lock-up
of funds increases.
periods, etc.). The explanation is likely to be other risks, e.g.
reduction of operational risks or lack of strong conviction
Looking across styles
about individual managers.
Diversifying across styles provided similar results. As one
would expect, we observed that smart diversification gives
Conclusion
better and faster results in terms of risk reduction than the
The proliferation of hedge funds, the increasing participation
naïve diversification approach, so that a fewer number of
of investors in alternative investments, the growing base of
funds is necessary to reach the same level of diversification.
articles analyzing hedge funds, and the ever-present
37
1
6
11
16
21
26
31
36
41
46
Number
of funds
24
1
6
11
16
21
26
31
36
1
22
0.9
20
0.8
18
16
0.7
14
0.6
12
0.5
10
0.4
8
6
0.3
Correlation with S&P500
Figure 8: Impact of diversification on the correlation with S&P 500
Figure 9: Impact of diversification on the correlation with CSFB indices
Global Macro:
Multi-strategies:
Global Macro:
Multi-strategies:
Convert. Arb.:
Fixed Income Arb.:
Convert. Arb.:
Fixed Income Arb.:
Long/short Equity:
Market Neutral:
Long/short Equity:
Market Neutral:
Managed Futures:
Emerging:
Managed Futures:
Emerging:
Event Driven:
Short Sellers:
Event Driven:
Short Sellers:
uncertainty of the future market conditions all give rise to a
greater need to choose the right funds. Although naïve diversification proves better than no diversification at all, smart
diversification proves even better. Using a smart approach to
diversification can enhance using diversification to hedge
against a bad decision. This is to say that if an investor wants
hedge fund exposure diversification choosing multiple hedge
fund styles is more effective than randomly choosing regardless of style. However, past ten funds, diversification is likely to
become diworsification and open the door to mediocrity.
38 - The
Correlation with CSFB indices
41
46
Number
of funds
References
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
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Quantitative Analysis, 6, 785-797
Newbould, G. D., and P. S. Poon, 1993, ‘The Minimum Number of Stocks Needed for
Diversification’, Financial Practice and Education, 3, 85-87.
O’Neal, E. D., 1997, ‘How many mutual funds constitute a diversified mutual fund
portfolio?’, Financial Analysts Journal, 53, 37-46
Ruddick, S., 2002, ‘Diversification Overkill’, working paper, Albourne Partners,
January
Scott, R. C., and P. A. Horvath, 1980, ‘On the Direction of Preference for Moments of
Higher Order Than the Variance’, The Journal of Finance, 35, 915-919
Statman, M., 1987, ‘How many stocks make a diversified portfolio?’, Journal of
Financial and Quantitative Analysis, 22, 353-363
Tole T., 1982, ‘You can’t diversify without diversifying’,
Journal of Portfolio Management, 8, 5-11
Upson, R., P. Jessup, and K. Matsumoto, 1975, ‘Portfolio diversification strategies’,
Financial Analysts Journal, 31:3, 86-88
Wagner, W., and S. Lau, 1971, ‘The effect of diversification on risk’,
Financial Analysts Journal, 27, 48-53
Description of investment styles
Global macro fund managers analyze the global macro-economic landscape in search of
opportunities to profit from trends or geo-political events. They typically invest in interest rates, currency markets, and equity markets, and their trades are often leveraged.
Famous managers include: Soros and Buffet.
Commodity trading advisors (CTAs), or Managed futures, trade financial, commodity
and/or currency futures globally. The trades are determined either via a systematic program or a discretionary analysis. Typical approaches include: trend-following, pattern
breakout.
Long/short equity managers are the most numerous in the universe. They attempt to
isolate alpha by investing long equities they believe will increase in price value, and short
equities they believe will decrease in price value. They can use pair strategies in an
attempt to neutralize their exposure to the market.
Dedicated short bias managers are stock-pickers who are net, and potentially, gross
short the market.
Emerging market managers invest in the equity and fixed income markets of emerging
economies. Due to restrictions in short-selling and lack of index derivative products, they
are most often either long or in a cash position.
Equity market neutral managers are akin to long/short managers in their stock-picking
approach; however, they execute trades only on stocks that will result in a net beta neutral position. A variation is the market neutral manager who is net zero in a sector, and
consequently, may have a long sector exposure. This approach may be either systematic or discretionary.
Event-driven managers trade company-specific events, which give rise to pricing inefficiencies between and among securities. Typical approaches include distressed debt, capital structure arbitrage, and merger arbitrage. Most managers employ multiple strategies, depending the opportunities in the market.
Fixed income arbitrage aims to profit from pricing inefficiencies among interest rates,
cash and derivative instruments. Approaches include yield curve arbitrage and curve
spread trading. Some managers may execute directional trades based on their bet on
the market evolution.
Convertible arbitrage managers attempt to profit from the miss pricing of convertible
bonds, which are a hybrid of fixed-income and equity holdings. They hedge credit and
interest rate risk, take profits on the difference between the cash inflows of the bond
coupons and the short interest rebates, and the cash dividend payout to the lending
equity holder. The convergence of prices between the long convertible position and
short equity position add profits. Approaches include volatility trades (gamma trading),
premium capture (inexpensive put), and credit plays (inexpensive call).
Multi-strategy funds attempt to capture the benefits of multiple hedge fund strategies
in one fund. Typically, multiple managers invest a book (or allocation), which is aggregated into the fund. The portfolio manager may actively change the allocations to the
strategies, or to each book, depending on the market conditions.
39
Risks
Valuation issues
and operational risk
in hedge funds
Christopher Kundro
Partner, Capco
Stuart Feffer
Partner, Capco
Abstract
In our recent study on the root causes of hedge fund failures,
we identified a number of operational risk factors that together
seem to account for approximately half of catastrophic cases.
Issues related to valuation - the determination of fair-marketvalue for all of the positions that make up a fund - underlie
many of these operational risk factors. Recently, valuation
problems have also been much in the news. These headlines
suggest that the industry is not yet taking the steps needed to
address problems in the valuation process. In fact, we believe
that issues related to valuation of portfolios will likely become
the next major 'black eye' for the hedge fund industry. Unless
certain practices discussed in this paper become more widespread, we believe that hedge funds face a potential crisis of
confidence with institutional and high net worth investors.
Therefore, we are using this paper to consider the issues
related to the valuation of hedge fund portfolios more closely,
in particular as they pertain to the issue of managing operational risks associated with hedge fund investments.
41
Introduction
managing operational risks associated with hedge fund invest-
In our recent study on the root causes of hedge fund failures,
ments.
we identified a number of operational risk factors that
together seem to account for approximately half of cata1
What is the valuation issue?
strophic cases . These factors included misappropriation of
The issue around valuations in hedge fund portfolios concerns
funds and fraud, misrepresentation, unauthorized trading or
how to ensure that a fund uses fair and proper prices for posi-
trading outside of guidelines, and resource/infrastructure
tions that are held in the fund. The net value of these posi-
insufficiencies. Issues related to valuation – the determination
tions, after fees and expenses, is the Net Asset Value (NAV) of
of fair-market-value for all of the positions that make up a
the fund, and is used as the basis for all subscriptions, redemp-
fund – underlie many of these operational risk factors. Most
tions, and performance calculations.
instances of fraud and misrepresentation involved some form
of deception regarding the value of assets held by the fund,
For some types of investments, in particular for non-concen-
and many of the resource/infrastructure problems we studied
trated positions in liquid securities, fair and impartial valua-
eventually manifested themselves through some form of
tions are fairly easy to achieve – recent transaction prices as
inability to accurately price or risk the funds book. While valu-
well as marketable bids and offers are readily available and are
ation issues were not specifically identified in our original
visible on major wires and feeds, such as Bloomberg and
study as a major category of operational risk on its own, vari-
Reuters. But, for many other investments favored by some
ous aspects of the valuation problem have played either a pri-
types of hedge funds, this is not necessarily the case. Some
mary or contributing role in more than a third (35%) of cases
securities may trade infrequently and transactional prices
of failures that we studied.
may not be available. In these cases, broker quotes must be
sought to get a sense for what the position is worth. Some
Recently, valuation problems have also been much in the
securities are highly complex, and may be difficult to value
news. They figure prominently in the SEC’s staff report on
without the use of a mathematical model. However, in thinly
‘Implications of the growth of hedge funds,’ in news accounts
traded markets quotes can be difficult to obtain and may be
of a high-profile departure of a top fund manager at a leading
unreliable (broker quotes for some types of mortgage backed
hedge fund group, and in the recent market-timing scandals in
securities can easily vary by 20-30%). Mathematical models
the mutual fund world (it being an issue with mutual fund val-
make use of assumptions and forecasts that are subjective
uations that creates the opportunity for market timers in the
and open to question.
first place).
Put these natural, inherent difficulties in pricing complex or
These headlines suggest that the industry is not yet taking the
illiquid investments together with a powerful financial incen-
steps necessary to address problems in the valuation process.
tive to show strong (or hide weak) performance, and then sit-
In fact, we believe that issues related to valuation of portfolios
uate these factors in an environment with minimal regulatory
will likely become the next major ‘black eye’ for the hedge
oversight, or without strict discipline and internal controls
fund industry. Unless certain practices (discussed below)
(still far too typical in the hedge fund industry), and there is
become more widespread, we believe that the hedge funds
potential for trouble.
face a potential crisis of confidence with institutional and high
net worth investors. Therefore, we are using this paper to con-
Trouble is precisely what the industry has seen. At Lipper
sider the issues related to the valuation of hedge fund portfo-
Convertibles, a convertible bond hedge fund that recently col-
lios more closely, in particular as they pertain to the issue of
lapsed, it appears that several portfolio managers made use of
1
42
Feffer. S., and C. Kundro, 2003, ‘Understanding and mitigating operational risk in
hedge fund investing,’ white paper series, Capco Institute, March
the opacity of the convertibles market to misvalue their port-
■ Fraud/misrepresentation - Occasionally a valuation
folio significantly. Similar issues were behind the collapse of
problem will be part of a deliberate attempt to inflate the
Beacon Hill and others.
value of a fund, either to hide unrealized losses, to be able
to report stronger performance, or to cover up broader
It certainly seems that these kinds of issues are increasing in
theft and fraud. This appears to have been true,
their frequency, severity, and visibility. This has been driven by
for example, in the case involving the failure of the
three key trends:
Manhattan Fund.
■ Mistakes or adjustments - As mentioned above, some
■ The increasing sophistication of financial instruments -
securities frequently traded by hedge funds can be
New types of structures are invented constantly.
extremely difficult to value. And even when prices are
Their complexity often make them difficult to price, and it
readily available, some positions may require adjustment
can be very difficult to guarantee standard or accurate
anyway - positions that comprise a large proportion of a
pricing procedures. In many of these cases valuation issues
single issue, for example, should be discounted to reflect
can be compounded due to the inherent or synthetic
the likelihood that they cannot be liquidated without a
leverage of many of these instruments.
significant market impact. Also, if a security is held in a
■ The increasing number of funds that are using complex
large enough quantity where public disclosure (i.e. Schedule
instruments - As the hedge fund market grows, new
13D) is required, an adjustment may need to be made if all
managers are emerging every day, and many of them are
or part of the position can not be sold anonymously.
focused on parts of the market where pricing and valuation
Occasionally, positions will simply be mis-marked, and may
issues are most prevalent.
cause a sudden and unexpected impact to fund valuation
■ A broadening investor base - Institutional investors are
when the marks are corrected or the position is reversed.
increasing their allocations to hedge funds, and some types
There can also be a significant variation depending on
of institutions which have not previously been sizable
which ‘correct’ price is being used – i.e., the bid, offer, or
hedge fund investors (e.g. pension funds) are aggressively
mid-point – especially when it comes to thinly traded or
entering the market. In addition, many funds-of-funds are
illiquid instruments where bid/offer spreads can be sizeable.
looking to push hedge fund like products to middle-market
■ Process, systems, or procedural problems - There are
and affluent retail investors. This has increased attention to
times when a fund may be following its own policies
the sector, and is resulting in increasing regulatory and
consistently and accurately, but a flaw in the valuation
media scrutiny.
procedures or processes cause a systemic mis-marking of
the book. This is most common in cases where a fund is
Because of this increased attention to hedge funds at a time
trading instruments that cannot be handled by its regular
when the factors that make pricing and valuation difficult are
processing systems and some kind of workaround is devised
becoming even more prevalent, we believe that valuation
which later proves to be flawed. Issues that may occur are
problems will likely continue to occur, and to attract significant
not limited to incorrect pricing. Entire positions can be
attention from the financial and general business press.
incorrectly captured on the fund’s books and records.
Sometimes total positions are completely excluded in error.
Causes of valuation problems
Mortgages, bank loans, OTC derivatives, convertible bonds,
When there are valuation problems at a fund they are gener-
and non-dollar instruments of all kinds can be prone to
ally caused by one of three factors:
these kinds of issues if underlying systems do not fully
support them.
43
Sometimes, even when technology support is robust and pro-
We believe that the likelihood of all of these types of valuation
cedures are both well-defined and widely monitored, flaws in
problems occurring can be reduced and their effects mitigat-
the valuation process can have wide-ranging effects. In the
ed should they occur, if the hedge fund industry begins to
recent mutual fund market-timing scandals, for instance, it
adopt some sound practices that have been common in other
was a flaw in the basic rules around fund valuations (reporting
parts of the financial industry for some time. These are dis-
values as of the end of the standard market day in the U.S.,
cussed in more detail below.
without adjustment for news that may have moved markets)
which created much of the opportunity for market timing in
Some strategies are more vulnerable than others
the first place.
While it is possible for any fund to experience valuation issues,
it has been our experience that some types of funds are more
Fraud/
Misrepresentation
57%
Process, systems,
or procedural
problems
30%
prone to the problem than others. Unless there is some kind of
broader fraud or malfeasance, funds that invest exclusively in
highly liquid instruments for which prices are readily available
(most U.S. and major-market equities, for example) are far less
likely to significantly mis-mark a portfolio than funds that trade
complex over-the-counter instruments or illiquid securities.
Mistakes or
adjustments
13%
We believe fund managers and investors should take particular care in looking at valuation procedures for the following
types of instruments:
Causes of valuation issues implicated in hedge fund failures
■ Convertible bonds - These can be extremely complex to
Other procedural factors that can affect valuation include:
value and have limited liquidity. Broker quotes for
when a quote is being obtained from a third party (e.g., bro-
convertibles can vary significantly for the same issue, and it
ker/dealer) as a basis for valuation, questions related to which
can be difficult to determine the size for which any given
third party and who at that third party can be critical. Is the
quote is good. (In one convertible portfolio we recently
broker/dealer a counterparty to that transaction and therefore
studied, for example, the average difference between
has a potential conflict of interest? Is the individual providing
highest and lowest bid on the same issue was around 5%,
the quote a junior or senior executive and are they truly capable of providing an accurate price, especially when complex
with the largest deltas as high as 20%).
■ Mortgages, mortgage-backed securities, and asset-
modeling is involved? The point is that sometimes ‘the devil is
backed securities - These are also difficult to value and
in the details,’ namely the task level procedures for obtaining
may be subject to both liquidity problems and high
prices on a regular basis.
dispersion of market-maker quotes. They also have special
processing requirements, and most firms that trade them
44 - The
In cases of hedge fund failures where valuation was a primary
must use a dedicated system for booking, valuing, and
or contributing factor (35% of the total), we found that fraud
processing these securities. Funds that trade these
and misrepresentation was the cause in 57% of cases.
instruments as part of a broader fixed-income strategy,
Process, procedural, or systems problems accounted for 30%
therefore, will often be carrying mortgage and asset-backed
of these valuation-related failures and mistakes or adjust-
securities on a different system from the rest of the
ments were implicated in the remaining 13%.
portfolio, requiring either integration or manual
intervention to consolidate. These systems and procedures
fairly actively traded securities with prices readily available
should get special attention by fund management or during
from independent third party sources can occasionally be
investor due diligence.
‘stale’ due to bad market feeds, human error, or other issues.
■ Credit default swaps - Credit derivatives are growing in
This has also been publicly discussed as an issue with mutual
popularity and are often used by hedge funds to take on
funds in recent months. Investors should take steps during due
credit exposure or to hedge a portfolio. Depending on the
diligence to ensure that all automated prices are validated
specific circumstances of the issuer covered by the swap,
prior to month-end valuations and as part of other reporting
these can also be difficult to unwind and market-maker
and subscription/redemption cycles.
quotes can be difficult to obtain.
■ Other over-the-counter derivatives - New types of
Recommendations to the hedge fund industry
complex swaps, options, and hybrids are being developed
We believe that the aforementioned problems could be largely
constantly, and some hedge funds will make use of highly
mitigated or averted if the hedge fund industry were to adopt
customized instruments in their portfolios. Procedures for
some practices related to valuations that have long been com-
valuing and booking these trades should receive special
mon in other parts of the financial sector. In particular, fund
attention.
management companies and investors should: 1) Insist on
■ Bank debt and loans, distressed debt - These are often
strict independence and separation of duties; 2) Ensure con-
both illiquid and difficult to model, requiring significant
sistency in the valuation process, and; 3) Require a level of
credit expertise.
management supervision and oversight. More details on these
■ Non-dollar and emerging markets - Many funds that
recommendations are included below.
begin with a focus on U.S. markets will put in place an
infrastructure that accommodates U.S. dollar-denominated
The Managed Funds Association has published a set of ‘Sound
securities, but may not properly book and track non-dollar
Practices for Hedge Fund Managers,’ which they recommend
securities. This additional processing complexity can, if
for adoption by the hedge fund industry,2 and the Internation-
these funds begin to trade in other markets without
al Association of Financial Engineers’ Investor Risk Committee
upgrading their infrastructure, create an environment that
has published a description of concepts related to valuation
is more prone than average to valuation mistakes and pro-
that they recommend as a basis for discussion between finan-
cessing problems. Securities issued in some emerging
cial institutions and stakeholders.3 While we agree with virtu-
markets, even when a fund is experienced with non-dollar
ally all of the concepts and practices that these organizations
investing, can be difficult to value and may be subject to
endorse, we believe that they do not go far enough in advo-
liquidity concerns as well.
cating more robust controls around valuations. Therefore we
■ Highly concentrated positions, and positions that make
make the following suggestions.
up a large proportion of a single issue - As mentioned
security that is not difficult to price) may require
Insist on strict independence
and separation of duties
adjustments to reflect the true liquidation value of the
Separation of duties and independence in mark-to-market has
position, and the fact that it cannot be disposed of without
long been a fundamental principle of control in financial insti-
a significant market impact.
tutions, but is still inconsistently applied in the hedge fund
above, these types of positions (even when in a highly liquid
industry. A breakdown in separation of duties seems to have
It is worth noting that while complex, thinly traded, or illiquid
been a factor in almost every valuation-related hedge fund
instruments are more likely to have pricing issues. In fact, even
failure that we have studied. In short, independence and
2 Managed Funds Association, ‘2003 Sound Practices for Hedge Fund Managers,’
published and distributed by the Managed Funds Association, Washington, DC, 2003.
3 International Association of Financial Engineers, Investor Risk Committee,
‘Valuation concepts for investment companies and their stakeholders,’ IAFE, 2003.
45
separation of duties means that the person who performs
use of better information, or for other good management rea-
checks or approves valuations should not receive incentives or
sons. However, when it appears that valuation choices are
inducements based directly on the performance of the invest-
made situationally, without a clearly documented rationale, we
ment being valued, and should not report to managers who do.
believe that an investor should seriously consider the safety of
their capital.
The trader or portfolio manager should never perform final
valuations (it often makes sense, however, for the trader or
Require a level of supervision and oversight
manager to do their own valuation as a ‘reasonableness check’
If the fund manager performs valuations themselves, there
on an independent process), and wherever possible an inde-
should be a set of clearly documented policies and proce-
pendent third-party should check valuations prepared by the
dures, as well as a way of ensuring that those polices and pro-
manager themselves. Wherever possible, a fund manager
cedures are actually followed in practice – generally through
should keep a financial/accounting staff independent of the
external validation, testing, and audit.
portfolio management team to prepare and validate marks-tomarket. In most cases, these staff will report to the CFO or the
After the collapse of Lipper Convertibles, Ken Lipper who ran
COO of the fund management company, and should be com-
the management company, commented to the media through
pensated based on the overall profitability results of the man-
his attorney that he was unaware of any mispricing issues
agement company rather than directly based on the perform-
prior to the collapse of the fund and that it had been valued by
ance of any of the investment vehicles managed by the firm.
the portfolio managers responsible for investing it. To us, if
true, this represents an abdication of management’s duty to
In some cases fund administrators will perform this role for a
oversee the valuation process. Management should review val-
fund manager. Some valuation services will also prepare
uations, and there should be evidence that pricing discrepan-
marks on an ‘outsourced’ basis for a fund manager. Many
cies have been brought to management’s attention and that
funds will also employ an auditor to test valuations used for
action has been taken when appropriate. Especially in a fund
financial statements to investors. We believe that a fund man-
that invests in the problem-prone instruments mentioned
ager should always use an external third party to verify that
above, a certain number of honest valuation discrepancies are
portfolio valuations are accurate before they are reported to
inevitable. Whether a fund manager acknowledges that they
investors. This would be in addition to the fund auditor, who
occur, how they handle them, and whether they document the
often will examine valuations less frequently and after they
results can speak volumes about the quality of supervision
have been reported.
over the valuation process. This management oversight is critical to ensuring the soundness and safety of investor assets in
Ensure consistency in the valuation process
a fund.
Daily mark-to-market and monthly/quarterly pre-statement
valuations should always be performed according to a well
Sometimes it can be smart for a fund manager to outsource
defined process. The application of sources, methods, rules,
some of the mechanics to a third party pricing service. Even in
and models should always be applied consistently, with any
the case of complex instruments – such as certain OTC deriva-
deviations or unusual circumstances clearly noted and docu-
tives and asset-backed securities – there are service providers
mentation saved.
that can price them and also offer operations outsourcing and
risk management services as well. We believe that any move
46 - The
These processes may change over time in response to
which increases the independence and objectivity of the valu-
changes in the markets for certain types of securities, to make
ation process should be viewed positively by investors.
Conclusion
Clearly, pricing and valuation has become a significant issue
for the hedge fund industry, and we believe that its significance is likely to increase – particularly as it relates to funds
that trade strategies and instruments that are particularly
prone to the types of problems we discuss here. But there are
a set of practices, long standard in other parts of the financial
sector, that we believe can mitigate losses and prevent problems, at least in many cases. We further believe that they represent the hedge fund industry’s best chance at avoiding a
damaging public ‘black eye.’
47
Risks
Hedge funds and
U.K. regulation
Ashley Kovas1
Manager, Business Standards Department,
Financial Services Authority
Abstract
Hedge fund regulation in the U.K. may be viewed as three distinct issues: (1) Systemic risk issues, following the near-collapse of LTCM; (2) The regulation of hedge fund managers –
many managers are established in the U.K.; and (3) Retail marketing. The position is complicated by the fact that the term
'hedge fund' is undefined and the funds themselves are not
established in the U.K..
1
Ashley Kovas writes in a personal capacity. The views expressed herein are those
of the author, and do not necessarily reflect the views of the Financial Services
Authority. This document does not constitute guidance for the purposes of section
157 of the Financial Services and Markets Act 2000. This document does not
provide a comprehensive statement of the law or the rules of the FSA. Readers
are advised that, where necessary, they should take appropriate professional
advice on the application of the rules to their own circumstances. Neither the
author nor the Financial Services Authority accepts any liability for loss caused by
reliance on anything written in this document.
49
The regulation of hedge funds, rather like the funds them-
■ Reducing financial crime – Reducing the extent to which it
selves, is a complex matter. This paper will explore the issue
is possible for financial crime to be carried on by a regulated
under three headings – (a) systemic risk issues; (b) the regula-
person or in contravention of the general prohibition.
tion of hedge fund managers, which is presently the U.K.’s
The FSA must have regard to the desirability of regulated
closest involvement with hedge funds; and (c) the develop-
persons being aware of the risk of their business being used
ment of retail hedge funds.
in connection with financial crime, taking appropriate
measures to prevent financial crime, and devoting
There are two important preparatory points to make:
adequate resources to fighting financial crime.
1 The FSA does not regulate hedge funds established outside
the U.K.. Regulation of the U.K. manager does not amount
The ‘protecting consumers’ objective requires a balance
to regulation of the fund itself.
between protection and consumers having responsibility for
2 There is no universally accepted definition of a ‘hedge
their own actions. In a hedge fund context, this has particular
fund’. Some commentators try to categorize hedge funds
relevance for retail marketing, which will be examined later in
by reference to the strategies they operate2. In particular,
this article.
new hedge fund strategies seem occasionally to be added
to the list, suggesting that the definition is open-ended.
3
There is some academic opinion that investors are
The Act also provides that the FSA must abide by a series of
‘principles of good regulation’4:
irrationally affected by an investment fund’s name. This in
turn could mean that the term ‘hedge fund’ is principally no
■ Efficiency and economy – This deals with the way the FSA
more than a marketing tool, intending to group absolute
uses its resources. When dealing with a specific risk, the
return strategies so as to distinguish them from other types
FSA aims to select the regulatory tools which are most
of funds.
efficient and economic. The FSA has decided to go beyond
the statutory obligation to consult regulated firms over the
The FSA's statutory objectives
The FSA is established by the Financial Services and Markets
Act 2000, which sets four statutory objectives for the regulator:
fees to be levied, and also consults on the FSA's budget
as a whole.
■ The role of management – This principle has two aspects
to it5. Firstly, it means that the FSA must guard against
■ Maintaining market confidence – Maintaining confidence
in the financial system in the U.K..
50
being too intrusive into firms’ affairs. In this interpretation,
the FSA must, in effect, hold back and allow regulated firms
■ Promoting public awareness – In particular, this includes
to run themselves. Secondly, and as a consequence, it also
promoting awareness of the benefits and risks associated
means that the FSA must hold senior management respon-
with different kinds of investment or other financial dealing
sible for risk management and controls within the firm.
and also the provision of appropriate information and advice.
■ Proportionality – Restrictions applied to firms through FSA
■ Protecting consumers – Securing the appropriate degree
rules should be proportionate to the expected benefits for
of protection for consumers. This must have regard to
consumers and the industry. The FSA takes into account the
differing degrees of risk inherent in different investments,
costs incurred by firms and consumers. We are required by
the differing degree of experience/expertise of different
the Act to undertake and publish a cost benefit analysis of
consumers, the needs consumers may have for advice and
any proposed regulatory requirements6. An example of
accurate information, and the general principle that
proportionality in action can be seen in the way in which the
consumers should take responsibility for their decisions.
FSA regulates the wholesale and retail markets differently.
2 Indeed, the FSA did this in Discussion Paper 16, Hedge Funds and the FSA,
see paragraph 3.2.
3 See P Raghavendra Rau et al, Changing names with style: Mutual fund name
changes and their effects on fund flows, available on the Purdue University
website: www.purdue.edu (an unpublished working paper).
4 Section 2(3).
5 See A New Regulator for the New Millennium, Financial Services Authority,
January 2000, page 10.
6 Section 155(2)(a) and (10).
■ Innovation – The FSA should facilitate innovation, e.g. by
derivatives (U.S.$ 150 billion). A number of the fund’s futures
avoiding unreasonable barriers to entry or restrictions on
positions represented more than 5% of the open interest in
existing market participants who launch new financial
the contracts concerned and in some cases amounted to more
products and services.
than 10%. The fund had some very significant positions in
■ International character of financial services and
individual securities.
markets and the desirability of maintaining the
competitive position of the U.K. – The FSA will consider
LTCM’s risks were crystallized by unusual market conditions
the impact on the U.K. markets and consumers of econom-
following Russia’s declaration of a Rouble devaluation and
ic, industry, and regulatory situations overseas. The FSA
debt moratorium in August 1998. Investors suddenly sought to
must consider the international mobility of much financial
avoid risk and a flight to quality ensued.
services business. The FSA will co-operate with overseas
regulators, to agree international standards and also to
‘[LTCM] was betting that liquidity, credit and volatility spreads
monitor global firms and markets effectively.
would narrow from historically high levels. When the spreads
widened instead in markets across the world, LTCM found
Systemic risk issues
itself at the brink of insolvency. In retrospect it can be seen
The systemic risk potential of hedge funds became apparent
that LTCM and others underestimated the likelihood that liqui-
through the near-collapse of Long-Term Capital Management
dity, credit and volatility spreads would move in a similar fashion
in August 1998. Long-Term Capital Portfolio LP (LTCM) was a
in markets across the world at the same time’7.
hedge fund, established in Cayman in 1994. The fund itself
was, therefore, a legal entity based outside the United
The fund’s capital of U.S.$ 4.8 billion at the start of 1998 fell to
Kingdom. The manager of the fund was Long-Term Capital
U.S.$ 4.1 billion by July. In August alone, capital fell U.S.$ 1.8
Management LP, based in Connecticut. There was also an
billion reducing the capital base to U.S.$ 2.3 billion – a capital
office of the manager in London. The management of LTCM
loss over the year to date of around 50%. Restructuring was
was characterized by quality. Among the management were
essential, but reducing the individual positions was made very
two Nobel laureates, Myron Scholes and Robert Merton, both
difficult because of their size.
of whom were enormously respected figures in the field of
finance.
In the event, the New York Federal Reserve Bank brokered a
bail-out of the fund by its counterparties and creditors, who
The perceived quality of the fund’s management seemed to be
would have lost most had the fund collapsed. Investments
borne out in the very high performance of the fund between
totaling around U.S.$ 3.6 billion were made into the fund. In
1995 and 1997. LTCM was engaged in convergence trades, the
this way, the responsibility and burden of resolving LTCM’s dif-
taking of offsetting positions in two related securities in the
ficulties remained with the counterparties that had allowed
hope that the price gap between them would move in a favor-
the fund to build up its positions in the first place. If the fund
able direction. However, LTCM was distinguished by its excep-
had collapsed, the repercussions may have spread far beyond
tionally large positions, at time assets exceeded U.S.$ 125 bil-
the fund and its investors, counterparties, and creditors. The
lion, to which leverage in excess of 25 to 1 was added. Just
sudden liquidation of its positions could have led to significant
before its near-collapse in August 1998, the fund held posi-
moves in market values of positions held by other market par-
tions with gross notional amounts of U.S.$ 1,400 billion made
ticipants.
up of contracts on futures exchanges (U.S.$ 500 billion),
swaps contracts (U.S.$ 750 billion), and options and other OTC
7 Report of the President’s Working Group on Financial Markets, April 1999
51
The President’s Working Group observed that: ‘[LTCM’s] posi-
stock for a hedge fund, his action would be consistent with
tions, combined with market volatility and lack of liquidity
selling it outright from his ‘conventional’ funds. A fund man-
might have led to a series of dramatic and punishing events
ager who could not justify a decision to lend stock for short
for LTCM’s trading counterparties and the markets themselves
selling purposes between two funds under his management
8
in the event of a default by the LTCM fund .’
may be in breach of the FSA’s rules10. Importantly, issues concerning equality of treatment may also arise where two con-
The experience of LTCM’s counterparties led them to rethink
ventional funds are run together. So, although they may arise
the terms of their business with hedge funds. The FSA contin-
in a different or perhaps stronger way, where a hedge fund is
ues to monitor the situation.
involved, the existing rules should deal with situations where
a fund manager does not treat one or other of his customers
Regulation of hedge fund managers
fairly.
General
Hedge fund managers tend to be relatively low risk according
Another point made to the FSA during the Discussion Paper 16
to the FSA’s ARROW process, meaning that they represent
exercise concerned systems and controls. FSA rules already
relatively low risk to the FSA in its fulfillment of its statutory
require that ‘A firm must take reasonable care to establish and
duties under the Financial Services and Markets Act.
maintain such systems and controls as are appropriate to its
business11’. Guidance to the rule gives greater detail on what a
Discussion Paper 16, Hedge Funds and the FSA, published by
firm might consider as relevant in assessing its systems and
the FSA in August 2002, discussed the U.K. regulation of
controls12:
hedge fund managers in some detail. The principal question
was whether the regulations applied to investment managers
■ The nature, scale, and complexity of its business.
generally are applicable for hedge fund managers, or whether
■ The diversity of its operations, including geographical
special rules are needed for hedge fund managers.
diversity.
Respondents suggested that the existing regime works ade-
■ The volume and size of its transactions.
quately for hedge fund managers, and the FSA was inclined to
■ The degree of risk associated with each area of its
agree9.
operation.
Some comment has been made from time to time that there
A number of respondents to Discussion Paper 16 suggested
are particular problems with fund managers managing hedge
that some hedge fund managers were seeking to manage
funds alongside other, ‘conventional’ funds, particularly in the
their funds with less than adequate systems and controls. This
conflicts of interest which this raises. For example, some have
would be a matter of concern and would, of course, amount to
suggested that stock might be loaned from a ‘conventional’
a breach of FSA rules. This is a matter which the FSA said it
fund to a hedge fund for the purpose of short selling it. In
would consider further13.
practice, a firm carrying out such a deal would frequently be
52
faced with a problem of consistency of approach. If the fund
Money laundering
manager is bearish on a particular stock, he would logically
The management of hedge funds is a particularly internation-
have the same opinion of the stock irrespective of the fund
al business. Frequently the parties concerned with the fund
holding it. So stocklending from a conventional fund to a
are based in different jurisdictions. Thus the manager may be
hedge fund would, absent special circumstances, be difficult to
in the U.K., the administrator in Ireland, and the fund itself
justify as logical. If the manager wishes to short sell a particular
established in Cayman. It has been suggested that this inter-
8 Ibid.
9 Feedback Statement to Discussion Paper 16 (March 2003), paragraph 3.15.
10 For example, Principles 1 (Integrity); 2 (Skill, care and diligence);
6 (Customers’ interests); 8 (Conflicts of interest) and also COB 7.1
(Conflict of interest and material interest).
11 SYSC 3.1.1R.
12 SYSC 3.1.2G.
13 Feedback Statement to Discussion Paper 16, paragraph 3.16.
national structure means that hedge funds may therefore be
made, the criminal offences are not committed. It is also an
particularly targeted by money launderers.
offence for a person to fail to disclose that he knows or suspects that another person is engaged in money laundering,
Hedge fund managers are rightly concerned to understand
where the knowledge or suspicion comes to the person ‘in the
their duties to verify the identity of their funds’ underlying in-
course of a business in the regulated sector17’. Importantly, the
vestors. The FSA’s Money Laundering Sourcebook provides that:
offence is also committed where the person ‘has reasonable
grounds for knowing or suspecting’, even if he does not, in
1 ‘A relevant firm must take reasonable steps to find out who
its client is by obtaining sufficient evidence of the identity
fact, know or suspect18. The offence carries a maximum penalty of five years’ imprisonment.
of any client who comes into contact with the relevant firm
to be able to show that the client is who he claims to be.
Clearly there is merit in performing verification checks to
2 If the client with whom a relevant firm has contact is, or
avoid the possible imputation of knowledge sufficient to
appears to be, acting on behalf of another, the obligation in
ground criminal liability under the 2002 Act.
(1) is to obtain sufficient evidence of both their identities14.’
In reality, hedge fund managers may need to rely on their
The client of the U.K. hedge fund manager will usually be the
administrators to carry out verification checks. This does not
offshore fund itself. Verifying the identity of the fund itself is
absolve the manager of his own responsibilities under the
unlikely therefore to be a problem. There is some argument
FSA’s Rules. Hedge fund managers will, therefore, need to
about whether, as a matter of law, a hedge fund acts ‘on behalf
decide what level of control or supervision to exert over the
of’ its investors. Indeed, there may be a difference in effect
administrator.
depending on the legal nature of the hedge fund itself. If the
hedge fund does invest on behalf of its investors an obligation
Retail hedge funds
arises under ML 3.1.3R(2) to verify the identities of the
Introduction
investors into the fund. The natural meaning of the words of
As mentioned above, the Financial Services and Markets Act
ML 3.1.3R is to oblige the hedge fund manager to verify the
sets statutory objectives for the FSA, including a requirement
identities of investors in the hedge fund.
to secure an ‘appropriate degree of protection for consumers’.
In devising the protection, the FSA is required to have regard
The legal argument over whether or not hedge fund managers
to, inter alia, ‘the general principle that consumers should take
are technically liable to verify the identity of the fund’s
responsibility for their decisions’. At present the U.K. retail
investors is not the end of the story. The Proceeds of Crime
market is not an easy place for hedge funds – their marketing
Act 2002 enacts a series of criminal offences. For example:
is constrained. One argument put to us by the hedge fund
industry is that consumer protection actually requires wider
‘A person commits a criminal offence if he enters into or
marketing of hedge funds. The industry points to the recent
becomes concerned in an arrangement which he knows or
performance of widely marketable retail investment products
suspects facilitates (by whatever means) the acquisition,
in the bear market. Hedge funds, it is argued, provide a means
retention, use, or control of criminal property by or on behalf
for retail investors to make money or at least reduce their loss-
15
of another person .’
es in periods of market downturn.
These are serious offences, carrying a maximum penalty of
Discussion Paper 16 sought views on the desirability or other-
fourteen years’ imprisonment16. If appropriate disclosures are
wise of opening the retail market to hedge fund products.
14 ML 3.1.3R.
15 Proceeds of Crime Act 2002, section 328(1).
16 Section 334(1).
17 Section 330(3).
18 Section 330(2).
53
Respondents to the Paper did not demonstrate any particular
and misunderstanding on the part of retail investors and,
desire to allow greater access to hedge fund products by retail
indeed their intermediaries.
investors. In addition, it is evident that allowing greater access
by retail investors to hedge funds is a much broader question
If the FSA were to consider allowing the wider marketing of
than might at first be thought. The term 'hedge fund' has no
hedge funds, the following matters, among others, would need
commonly accepted definition so the question, in the U.K. at
to be considered:
least, becomes whether the retail regime should embrace a
significant tranche of what are presently unregulated prod-
■ Marketability - The extent to which the products are to be
ucts. For these reasons, the FSA decided not to change the
marketable. If restrictions on marketing are to remain,
rules to allow for retail hedge fund products. However, our
questions arise as to how the investor base should be
statutory objectives require the FSA in any event to keep the
stratified. Internationally there are three methods of
matter under review and the Feedback Statement said:
stratification – net worth of the investor, sophistication of
the investor, and/or ability to meet a minimum investment
‘…we recognize that the regulatory status of presently unreg-
threshold.
ulated schemes needs to be kept under review. We will contin-
■ Investor eligibility - It is possible to create rules to prevent
ue to discuss the possibility of a new approach with market
the fund itself from accepting investors unless they meet
participants. This new approach would allow for a broader
certain criteria. Some party will, therefore, need to accept
range of funds to be brought into the regime for retail invest-
responsibility for ensuring that all investors in the fund
ment products19’.
reach the eligibility criteria.
■ Domicile of fund - The extent to which hedge funds, as
The question of greater retail hedge fund investment is likely
opposed to hedge fund manager, should be encouraged to
to persist.
establish in the U.K.. This would have taxation implications
and so would not be solely an FSA matter.
Greater retail marketing for hedge funds raises many issues,
explored in greater detail below. These reinforce the fact that
■ Disclosure - Requirements for investors to be provided with
certain information.
opening hedge funds to the retail market would be a signifi-
■ Distribution - Rules may need to be applied to the manner
cant step to take in the U.K., which can perhaps best be appre-
in which retail hedge funds are distributed. For example,
ciated by looking at the issue through the eyes of the retail
rules may be applied to the selling process, or possibly
investor. The present range of widely marketable retail products
responsibilities applied to the product provider to ensure
does not carry as wide a range of risk and return possibilities
that intermediaries are enabled to distribute the products
as do unregulated funds, such as hedge funds. In short, it is
much more likely that a hedge fund will collapse with a signif-
competently.
■ Product regulation - The extent to which the product
icant or total loss of capital than is the case with retail funds.
structure or the operation of the fund should be subjected
In January 2003, for example, a Japanese Fund called 'Eifuku'
to regulation.
collapsed spectacularly over a period of one week, despite
calm trading conditions. There was no fraud alleged. The
Present position
manager simply adopted the wrong strategy. Total loss is an
The FSA’s present approach to hedge funds is driven by the
unlikely contingency for U.K. retail funds, at least absent fraud.
legal nature of the fund. If the fund is structured as a company,
Opening the retail market to hedge fund related products,
it can be marketed only in accordance with its relevant corpo-
therefore, creates the prospect for mis-buying, mis-selling,
rate structure. The FSA is not prepared, at the present time, to
19 Feedback Statement to DP16, Hedge Funds and the FSA, paragraph 4.15.
54
admit single manager hedge funds to the Official List. Funds of
What about the long-term?
hedge funds may be listed.
The Feedback Statement to DP16 made clear that the FSA
would continue to monitor the situation as regards retail mar-
Where the fund is structured as a collective investment
keting of hedge funds. Some other European (and other) coun-
scheme, it would not satisfy the requirements for FSA author-
tries have recently been revisiting their regulatory approach
ization. The fund will, therefore, be marketable in accordance
to hedge fund products. Germany has recently announced a
with the rules for unregulated collective investment schemes
regime for wide marketability of funds of hedge funds for
generally. These are set out in the FSA's Handbook20. In brief,
retail investors.
unregulated collective investment schemes can be marketed
to persons who are, or have recently been, participants in
The key issue is investor understanding, or more specifically
similar schemes, and persons for whom an authorized firm
the scope for investors to mis-buy, have mis-sold to them, or
has taken reasonable steps to ensure that the investment is
to misunderstand the nature of complex products. The U.K.
21
suitable .
has been subject to several recent instances of mis-selling. If
hedge fund products were to have greater marketability to
There are presently no rules applied to investor eligibility in
retail investors, it would be important to ensure that they can
hedge funds.
avoid these problems.
Hedge funds do not choose to domicile themselves in the U.K.,
The European Parliament recently debated a report ‘on the
essentially for tax reasons. There are requirements for disclo-
future of Hedge Funds and Derivatives’. This report, and its
sure by both companies and unregulated schemes (see COB 10
contents for the establishment of a cross-border marketing
for schemes). Product regulation is not applied to unregulated
regime for ‘sophisticated alternative investment vehicles’
schemes.
(‘SAIVs’), are discussed in this issue of the Journal.
Interestingly, Mr. Purvis, the author of the study, has not pro-
Near future
posed adding to the existing UCITS regime for cross-border
In May 2003, the FSA published Consultation Paper 185, The
fund marketing. This suggests that he recognizes that it is
CIS Sourcebook – A New Approach. CP185 suggests a sub-
important for retail investors to understand whether any given
stantial revision of the regime for authorized schemes. This
product is a UCITS or a SAIV. In addition, Mr Purvis' report
includes the establishment of a new regime of authorized non-
does not seek to define a ‘hedge fund’ – indeed he recognizes
retail funds. Those products would enable the authorization of
that there may be no grounds to discriminate against other
U.K. domiciled funds with significantly less product regulation
types of ‘alternative’ investment vehicles in favor of ‘hedge
than currently applies to authorized retail funds. Retail
funds’.
investors (with the exception of expert private customers)
would not generally be eligible to invest, nor would they be
The Report and debate will serve to inform the European
open to have non-retail funds marketed to them.
Commission on its own approach to hedge funds and other
alternative investment vehicles.
The authorization by the FSA of hedge fund related products
is an important step. This will enable the FSA to become much
more familiar with the day-to-day operation of hedge fund
related products.
20 COB 3, Annex 5.
21 The person to whom the scheme is promoted must be an established or newly
accepted customer of the firm or of a person in the same group as the firm.
55
Risks
Should you,
would you,
could you invest in
hedge funds?
George Feiger
Executive Vice President and Head of Wealth
Management, Zions Bancorporation
Pascal Botteron
Head of Hedge Fund Products Structuring,
Pictet Asset Management
Abstract
Hedge funds have become the darling of investors due to their
presumed capacity to make money under all market conditions. Some are certainly worth investing in, and can augment
a portfolio in very attractive ways. At the same time, they
carry not only more but quite different risks than do portfolios
of liquid securities. If you do not have the skills to evaluate
these risks, don’t invest. Using an agent in the form of a fundof-funds advisor instead of investing directly has a lot of
advantages, but not that of reducing the skill required. If you
can not evaluate the fund-of-funds manager, do not invest.
57
Promises and realities
If you have heard a sales pitch for hedge funds, then you have
350
■ More consistent performance through market ups
and downs.
■ Low volatility relative to the rest of the portfolio.
■ Diversification benefits due to a very low correlation
between hedge fund returns and those of conventional
Average
return
Standard
deviation
CSFB/Tremont
MSCI
S&P500
Russel 2000
10.09%
3.71%
7.81%
4.48%
8.86%
14.99%
16.27%
20.01%
300
heard four promises. Relative to liquid securities or mutual
funds, hedge funds are said to have:
Yearly basis
250
200
150
100
CSFB/Tremont
MSCI
50
S&P500
Russel 2000
assets.
■ Greater liquidity than that provided by ‘alternative
0
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
investment’ classes like private equity, venture capital,
and timberland.
Figure 1: Average return of indices
It is not easy to evaluate these claims, because hedge funds
before funds open themselves to public investors (called back-
are relatively new, they are secretive by the nature of their
filling bias). This occurs because most of the thousands of
trading strategies, and the available information is optimisti-
hedge funds are under 3 years in age and create a perform-
cally biased for various reasons which we will explain. Subject
ance history from a combination of trading in their current form
to these qualifications, here is what the available data tell us.
and prior trading by the same management team. From academic studies such as Fung and Hsieh (2000), Cross Border
Performance consistency
Capital, (2001), and Lazard (2001), we can extrapolate that this
At an aggregate level, hedge fund indices exhibit more consis-
bias exaggerates returns by between 3% and 5% per annum.
tency of performance than do market aggregate indices. As
Figure 1 shows, the CSFB/Tremont hedge fund index implies a
Beyond the biases, no one can actually buy the fund of all
higher mean return with lower volatility over the past ten
hedge funds that the aggregate indices represent1, whereas
years than common stock market indices.
they can buy the indices of liquid asset returns with which
they are compared. An investor is actually able to buy into a
This hedge fund index does not, alas, correspond to investor
hedge fund following some explicit strategy or style or, into
reality. First, the reported hedge fund numbers are biased
explicit fund-of-funds structures which mix managers and
upwards. Fee levels for arranging intermediaries are very
styles. The industry has more or less settled on the Tremont
aggressive in this industry (typically, a 1.5% management fee
structure of hedge fund styles described in Figure 2. The
and a 10% high-water-mark performance fee). Investing in an
reported results of the last 10 years are provided in Figure 3.
index-like diversified portfolio of hedge funds set up by an
advisor requires the payment of these fees in addition to those
One sees immediately that individual styles have been signifi-
charged by hedge funds and already subtracted from the
cantly more volatile than the notional overall hedge fund
index. Second, there is survivor bias in the reported numbers
return index. The implication of Figure 4 below is that mixing
because many hedge funds (in 2002, perhaps as many as
the styles in proportions different than the overall index can
20%) go out of business each year. Third, there is some actual
produce much less favorable results.
cheating in reporting, related to the period of own performance
1
58 - The
As an indication, the CSFB/Tremont index used as a reference in this article,
is built on the TASS database which tracks over 3000 funds. The universe of this
index consists only of funds with a minimum of U.S.$ 10 million under management and a current audited financial statement. Funds are separated into primary
sub-categories based on their investment style. The Index in all cases represents
at least 85% of the assets under management in the universe.
Directional strategies
Long/short equity directional
Take long and short positions with a directional bias by investing in equities or indexes
Emerging markets
Take long or long/short positions in all asset classes in emerging markets
Dedicated short biais
Take short positions in all asset classes
Global macro
Exploit macro-economic anomalies between regions
Managed future and CTAs
Identifies market signals/trends and uses derivatives to leverage the movements
Non directional strategies
Risk arbitrage
Exploit return opportunities associated with events such as LBOs,
mergers and acquisitions
Convertible arbitrage
Exploit arbitrage opportunities on spread by pricing inefficiencies between
securities of the same issuer
Fixed income arbitrage
Exploit arbitrage opportunities on spread by pricing inefficiencies between
bonds of two or more issuers
Long/short equity market neutral
Take long positions that cover short positions to create a zero directional bias
Distressed securities
Invest in securities of companies facing bankruptcy
Asset backed securities
Exploit arbitrage opportunities between underlying assets and packages
Figure 2: Understanding hedge funds
number of funds of hedge funds. For example, Ineichen (2002)
shows, for a sample of 475 funds of hedge funds, that the dispersion of volatility is significant: 19.4% had volatilities of 5%
or lower; 34.1% were between 5% and 10%; 24.6% were
between 10% and 15%; 11.2% were between 15% and 20%; and
10.7% had annual volatilities higher than 20%.
We believe that the fund of hedge funds industry is probably
as heterogeneous as the hedge fund industry itself. This
means that hedge fund indices are a pretty useless guide to
the likely outcomes of an actual investment, even in a fund-offunds.
350
300
250
Yearly basis
Average Return
Standard deviation
CSFB/Tremont
Ded Short Bias
Emerging Markets
Equity Mkt Ntrl
Event Driven
Distressed
E.D. Multi-Strategy
Risk Arbitrage
Fixed Inc Arb
Global Macro
Long/Short
Managed Futures
10.56%
10.52%
0.42%
4.97%
10.82%
10.60%
12.37%
9.68%
7.94%
6.78%
14.01%
11.24%
6.79%
8.70%
4.87%
17.84%
18.60%
3.14%
6.36%
7.32%
6.69%
4.59%
4.11%
12.44%
11.25%
12,27%
Figure 3: Style risk/return summary
Source: Based on CSFB/Tremont (www. hedgeindex.com)
This problem emerges in practice. The available evidence on
200
150
100
50
1993 1994 1995 1996
1997 1998 1999 2000 2001 2002
CSFB/Tremont
E.D. Multi-Strategy
Risk Arbitrage
Ded Short Bias
Fixed Inc Arb
Emerging Markets
Global Macro
Equity Mkt Ntrl
Long/Short
Event Driven
Managed Futures
Distressed
fund-of-funds returns shows significantly greater volatility
than the notional overall hedge fund return index for a large
Figure 4: Average return of CSFB/Tremont sub-indices
59
Equity market neutral
Event driven
Global macro
Long/short
Merger arbitrage
Relative value
Short selling
Distressed securities
Period
Oct 98
Maximum reported
0.08%
indice return
Hennessee
Emerging markets
Hedge fund strategy
Aug 98
-26.65%
MAR
Dec 99
5.2%
Van Hedge
Aug 98
-6.71%
Altvest
Oct 98
0.2%
Van Hedge
May 00
12%
HF Net
Feb 00
-1.56%
EACM
Sep 98
-0.11%
Altvest
Sep 98
-6.07%
EACM
Feb 00
-24.3%
Van Hedge
Aug 98
-12.08%
HF Net
Minimum reported
indice return
-4.67%
CSFB
-7.2%
Altvest
0.2%
Hennessee
-11.77%
CSFB
-10.78%
HF Net
-5.8%
Van Hedge
20.48%
Zurich
1.74%
HFR
-4.40%
Van Hedge
-3.097%
EACM
-4.70%
Van Hedge
GAP
4.75%
19.45%
5%
5.06%
10.98%
17.80%
22.04%
1.85%
10.47%
21.20%
7.38%
Figure 5: Spread between maximum and minimum within-style returns
Source: Anenc and Martellini (2002)
This should not be surprising – it follows from the free-ranging
First, we need to consider the implied information content of
logic of the hedge fund concept itself. Each hedge fund devel-
the volatility, which is the standard deviation of the portfolio.
ops an absolute return strategy using the specific skills and
For conventional liquid assets, investors are comfortable that
focus of its managers. For instance, two long/short managers
volatility estimates capture the essence of the investment
can generate very similar historical returns but with very dif-
risks that they face. For liquid assets, investors are in a good
ferent long/short strategies. One can be long/short in phar-
position to assess a wide variety of risks - market, credit, oper-
maceutical stocks and the other in food stocks. Benchmarking
ational - and factor these into their valuation of the assets.
one manager against the other is of pretty limited value. It
Their trading reflects this knowledge and thus it is reasonable
makes much more difference which specific hedge fund you
to argue that measured volatility captures this knowledge.
invest in than which style you invest in.
By contrast, the measured return volatility of hedge funds
Such evidence as we have about the returns of managers sup-
contains only very limited information about the overall mag-
posedly following the same style tells us the same thing.
nitude of the risks an investor embraces by putting money into
Figure 5 summarizes the results of Amenc and Martellini
the fund. For hedge funds, reported return volatility is not the
(2002) on the difference in monthly index returns among
outcome of competitive prices driven by broadly informed
funds supposedly following the same style.
traders. This volatility constitutes only the self-reported variability of the financial returns of the hedge fund strategy, peri-
Again we arrive at the conclusion that which fund you invest
od. No risk associated with the quality of the hedge fund
in dominates all the categorizations of styles because per-
(fraud, leverage, etc,) is contained in this measure of volatility.
formance variation across funds following a particular style is
Reported hedge fund volatility is just the tip of the iceberg of
much greater than variation across the average style per-
economic risk in investing.
formance indices.
Second, statistical issues also make measured volatility not
60 - The
Low volatility
very informative to an investor assessing investment risk. A
Here we come to some fundamental but unfortunately com-
hedge fund’s self-reported net asset value (NAV) is computed
plicated points about terminology and measurement.
on a monthly or quarterly basis, which enables the fund man-
CSFB/Tremont
Ded Short Bias
Emerging Markets
Equity Mkt Ntrl
Event Driven
Distressed
E.D. Multi-Strategy
Risk Arbitrage
Fixed Inc Arb
Global Macro
Long/Short
Managed Futures
MSCI The World Index
MSCI North America
MSCI Europe
MSCI Pacific
S&P500
Russel 2000
CSFB/
tremont
Convertible
arbitrage
100%
41%
-47%
65%
33%
66%
57%
67%
37%
45%
86%
78%
8%
47%
49%
44%
25%
48%
-9%
100%
-23%
34%
31%
60%
53%
61%
41%
55%
30%
26%
-24%
11%
13%
11%
-1%
13%
1%
Ded
short
bias
100%
-57%
-38%
-61%
-61%
-53%
-46%
-7%
-12%
-73%
27%
-74%
-76%
-58%
-56%
-76%
5%
Emerging Equity
markets Mkt Ntrl
100%
23%
70%
61%
70%
43%
30%
40%
59%
-16%
53%
49%
47%
43%
48%
4%
100%
38%
36%
36%
31%
8%
20%
36%
13%
39%
41%
29%
31%
41%
-3%
Event Distressed E.D.
Risk
Fixed inc
driven
multi- arbitrage
arb
strategy
100%
94%
93%
68%
38%
36%
66%
-25%
58%
56%
53%
42%
56%
0%
100%
77%
57%
30%
30%
59%
-18%
57%
55%
49%
44%
55%
1%
100%
66%
43%
41%
63%
-28%
51%
48%
48%
34%
48%
-1%
100%
12%
11%
50%
-27%
45%
43%
48%
27%
44%
-8%
100%
46%
20%
-10%
2%
3%
6%
-3%
2%
-1%
Global
macro
Long/
short
Managed
futures
100%
42%
24%
18%
23%
19%
-6%
23%
-12%
100%
-10%
62%
60%
57%
43%
59%
-6%
100%
-22%
-27%
-21%
-4%
-27%
3%
MSCI
the
world
index
100%
94%
90%
73%
94%
-2%
Figure 6: Correlation between hedge fund strategies and equity indices. Source: based on CSFB/Tremont
ager to smooth the volatility of returns. Information that cre-
we use it because funds typically follow consistent strategies
ates fluctuations in traditional assets may affect the self-
over time. Hedge fund managers tend to follow very dynamic
reported NAV with a delay, with damped effect or not at all.
investment strategies and past volatility cannot be blindly
Consider, for example, the events following September 11. What
assumed to be a good guide to future volatility.
most market actors would describe as a market crash followed
by a threatening lack of liquidity was simply ignored by hedge
These seemingly theoretical points are very clear to market
funds - because it happened in the middle of a month, that is,
professionals. A better estimate of the underlying risk of
between two NAV computations.
hedge funds emerges from the implied volatility of options
written on funds of hedge funds. Although the fund of hedge
Third, volatility, that is, portfolio standard deviation, is a useful
funds index has a volatility of 5-8%, the implied volatility of
performance measure when returns are more or less (log)
the option is 2 to 3 times higher.
normally distributed. Then ideas like confidence intervals
around the mean can capture likely outcomes. Because of the
Diversification benefits
kind of investment strategies followed, hedge fund returns are
The hedge fund salesman shows you the efficient frontier with
not normally distributed. Low measured volatility does not
and without hedge funds, and says that because hedge funds
necessarily imply low risk because hedge funds often behave
have a low correlation with liquid assets, you can achieve bet-
differently in up and down markets. This asymmetry will not
ter risk/return tradeoffs by including hedge funds in your port-
be captured adequately by the (symmetric) volatility measure.
folio. The correlation between reported overall hedge fund
Investors, who are more concerned by the risk of loss than by
performance measures and indices of liquid asset returns has
the risk of achieving very large returns, need a much more
certainly been low for some hedge fund strategies. However, it
sophisticated set of measurements.
is not low for all of them.
Fourth, volatility must be estimated from past outcomes. This
Figure 6 shows that the CSFB/Tremont index has significant
is of course true for the world of liquid securities as well. There
correlation with the main international equity indices. Still, the
61
Ded Short Bias
Emerging Markets
Equity Mkt Ntrl
Event Driven
Distressed
E.D. Multi-Strategy
Risk Arbitrage
Fixed Inc Arb
Global Macro
Long/Short
Managed Futures
FundCSFB/Tremont
Hedge Fund Index
Breakdown
of style
(source
TASS)*
Correlation to
MSCI (Jan 1994 March 2003) /
monthly data
Period 1
(Correlation to MSCI (Jan 1994 Dec 1996) / monthly data)
Period 2
(Correlation to MSCI (Jan 1997 Dec 1999) / monthly data)
Period 3
(Correlation to MSCI (Jan 2000 March 2003) / monthly data)
5.50%
0.40%
3%
6%
19%
19%
19%
19%
5.60%
8.50%
49%
3%
100%
11%
-74%
53%
39%
58%
57%
51%
45%
2%
18%
62%
-22%
47%
22%
- 57%
29%
25%
56%
69%
19%
- 3%
28%
35%
62%
15%
45%
23%
- 82%
71%
61%
72%
70%
70%
64%
5%
27%
80%
- 6%
60%
11%
- 78%
65%
29%
46%
37%
47%
34%
- 13%
- 2%
35%
- 51%
33%
Figure 7: Correlation between hedge fund strategies and equity indices*. Source: Based on CSFB/Tremont
* These correlation figures can be unstable over time because HF managers adopt different strategies over time. The benefit of incorporating hedge funds in a portfolio is,
thus highly dependant on the existing investor portfolio.
correlation is far from 100%. So, theoretically, hedge fund
Liquidity
investments can generate better diversification for investors.
At last, a true claim. The liquidity of hedge funds is almost
But, even neglecting our points above about the validity of
always significantly less than that of any kind of tradable asset
financial volatility measures for hedge funds, this is all in the
fund and in some cases, approaches the illiquidity of other
realm of theory. Because an investor cannot invest in some
alternative asset classes. However, redemption periods for
abstract or notional hedge fund index, the only relevant diver-
most hedge funds and funds of hedge funds are between 1 and
sification benefits are those attainable from style investing or
3 months. This indeed makes hedge funds more liquid than
fund-of-fund investing. Figure 7 shows that there appears to
such alternative investments as private equity and real estate.
be significant correlation between some hedge fund styles and
liquid investments. In particular, we can see that some hedge
fund styles are highly correlated (correlation >50%) with
financial markets and these hedge funds represent up to 70%
of the funds entered in the TASS database. Only a limited
Age of
fund
Range of estimation
for returns
Range of estimation
for survivorship bias
Range of estimation
for return including
survivorship bias
Low
High
Low
High
Low
High
22.40%
18.25%
17.37%
16.80%
13.30%
14.50%
13.10%
23.80%
18.70%
18.90%
17.39%
14.59%
15.61%
15.34%
0.90%
1.60%
1.70%
1.40%
1.10%
0.90%
0.50%
2.90%
2.60%
2.00%
1.50%
1.20%
0.90%
0.70%
19.50%
15.65%
15.37%
15.30%
12.10%
13.60%
12.40%
22.90%
17.10%
17.20%
15.99%
13.49%
14.71%
14.84%
number of strategies appear to be essentially uncorrelated
with the markets (convertible arbitrage, fixed income arbitrage, global macro, managed futures). Perhaps by coincidence, perhaps not, the majority of good funds in these areas
are already closed to new investors.
Most of today’s hedge fund population consists of Long/Short
1
2
3
4
5
6
7
funds. A significant fraction of these funds are highly correlated with financial markets and, thus, would not add a substantial diversification benefit to an investor’s portfolio.
62 - The
Figure 8: Estimation of survivorship biases.
Source: Lazard (2001) and Cross Border Capital
In summary, we may say the following. Overall, hedge funds do
Here is more to think about. New hedge fund managers are
have some of the benefits claimed for them, though not as
often refugees from the trading operations of banks and bro-
many as a typical sales document would suggest. But what is
kers. Many of these institutions have converted their propri-
overwhelmingly clear is that the specific choice of the
etary trading operations into publicly accessible hedge funds,
fund/manager is more important than any of these conceptual
so that the funds trade with investors’ capital and not that of
benefits.
the bank.
What to invest in
If hedge funds are such a wonderful investment, why have the
Because the choice of manager is the most critical one, and
banks done this?
because of the very wide variation in manager performance,
as with other assets a very important tool in managing risk is
Bank risk managers have increasingly concluded that these
diversification across a significant number of apparently well
trading activities are not the best use of the risk capital of the
managed hedge funds.
bank. They have also been troubled by the outsize compensation demands from proprietary traders. In essence, the avail-
How easy is it then to invest in a significant number of well
ability of investor capital and an infrastructure of prime bro-
managed hedge funds? These are funds run on a reasonable
kers handling many operational details of hedge funds have
scale by experienced managers who have been through some
combined to break the banks’ historic monopoly on propri-
market cycles and events and have shown that they can han-
etary trading. The influx of independent proprietary traders in
dle difficulties and manage the tough operational issues of the
the hedge fund industry has driven down the returns and
business. (The argument is the same at one remove if the
increased the risk of the trading strategies being followed.
investor invests in funds-of-funds). New and young hedge
funds are most likely to go out of business. Figure 8 gives an
As a result, the available market represents greater market
estimation of the performance and of the survivorship bias.
risk and operational risk than implied by the publicized performance numbers of the hedge fund industry. It requires cor-
The problem, of course, is that well-established hedge funds
respondingly greater skill to evaluate.
with reasonable scale and good track records are closed to
new money. In essence, the key drivers of the attractive return
How to structure hedge fund investments?
history and reputation of hedge funds are not accessible even
Investors should invest in good hedge funds. Industry profes-
to the typical wealthy investor, who must buy into relatively
sionals will tell you that a good fund is at least 3 years old, has
new and untried managers.
consistently returned good performance, and is of viable size.
As the hedge fund industry has evolved, the number of funds
The new managers have not managed an independent fund
has increased and the number that both meets this profile and
before, nor have they managed people in a small, entrepre-
remain open to new investors has fallen.
neurial organization. They tend to come from larger businesses where risk management and tracking, record-keeping, posi-
An investor has two choices:
tion-keeping, credit approval, and other logistical processes
■ Invest with a fund of hedge funds advisor, appealing if the
were done by others. In addition to being untried hedge man-
advisor will give access to closed funds, will provide skilled
agers, they represent significant operational risk relative to
advice, and has conducted in-depth due diligence on the
more established players.
funds. These services come at a price. In addition to the
management and performance fees of the hedge funds, the
investor will also pay management and performance fees to
63
the advisor. In addition, redeeming from a fund of hedge
funds is sometimes associated with an exit penalty
(redemption fee).
■ Invest in hedge fund manager(s) directly. This is cheaper in
terms of monetary costs but necessitates in-depth due
diligence by the investor.
fraction of his personal fortune in the fund? If not,
do not invest!
■ Follow-the-smart-money-in principle - Have the very rich
and famous already invested in the fund? If so, this is a
good sign.
■ Risk control well in hand - Has the manager set up an
independent risk control function in the back office? If not,
Choosing either a hedge fund or a fund of hedge funds
corporate governance and compliance problems can occur,
involves hard work. Due diligence questionnaires typically
there are potential risks of fraud, wrong NAV computations,
contain more than 300 questions on strategy, compliance
issues, etc.
model risks, breach of limits etc. Don’t invest!
■ External validation - Does an auditor regularly review the
manager? Can we see a copy of the most recent report?
The risks under scrutiny are the same as those analyzed by
risk managers in other financial firms making trading decisions:
If not, do not invest!
■ Management skills - Has the manager managed people or
a department in the past? If not, has an experienced COO
been hired? If not, best keep away.
■ Strategy risk - Inadequate formulation/application of
a strategy.
■ Market risk - Change in a market variable.
Can have a direct or an indirect effect.
■ Truth in advertising - Can we verify the references of the
manager? Were effective background checks used in the
selection of his staff? If not, forget it.
■ Apparent performance - Can the manager provide a back
■ Credit risk - Default by a counterparty.
testing analysis of what the performance has (would have2)
■ Operational risk - People, process, management, or system
been in the past? If not, do you have the courage to invest
failures; model risk; legal; external; or compliance failure, etc..
in untried ideas?
■ Liquidity/treasury risk - Ability to convert into cash.
Unfortunately, there is more. You can not sleep well at night
Moreover, the management team of a hedge fund is typically
once the investment is made. Things might go wrong, and you
very small relative to that of any other type of financial insti-
have to monitor activity very frequently. Once again, here are
tution. Hedge funds outsource as much as possible, so a risk
the considerations:
analysis must also cover the agents that service the hedge
fund, the prime brokers, and other transaction and reporting
organizations.
■ Incentives - Is the manager re-investing a significant
fraction of his personal profits in the fund? If not, clear out!
■ Follow-the-smart-money-out principle - If the very rich
Due diligence
As they say in another context, there is no substitute for diet
and exercise. Facing a small investment operation composed
and famous are pulling out, follow them immediately.
■ Management skills - If there is a turnover in the number of
employees in the fund, consider clearing out immediately.
of a limited number of personnel supporting a few managers,
■ Consistency of activity - If the manager enters investment
an investor must be very comfortable with how the managers
areas outside his original demonstrated skill, ask why these
deal with risk. We give the due diligence issues in their order
should prove profitable. If the answer does not sound too
of importance.
■ Incentives - Has the manager invested a significant
convincing, say goodbye.
■ Performance record - There is some evidence in the available
2 Would have been – if it is a young manager.
64
record that top quintile and bottom quintile performance tend
to persist. Draw your own conclusions from this.
■ Are the advisor’s limits on style allocation and on maximum
investment per hedge fund likely to maintain the desirable
risk characteristics?
In summary, monitoring direct hedge fund investments is just
■ Is the fund adequately diversified across managers?
as complex as selecting them. It requires not only data and
Experience suggests that fewer than 20 funds constitute
modeling skills but good connections in the hedge fund world
too little diversification and more than about 30 become
to get early notice of the rats abandoning the ship. If you can
unmanageable.
not do this, do not invest directly.
Operational supervision
Selecting a fund of hedge funds advisor
A hedge fund will not answer the above questions for an
■ Does the fund of hedge funds manager check the reported
fees and NAVs? Administrators sometimes make mistakes.
investor, unless that investor has a lot of money (or the manager is new and desperate, an answer in itself). For most
If this is not enough, selecting a fund of hedge funds advisor
investors, it may be worth investing through a fund of funds
is expensive with fees running up to 400 basis points. We
advisor. The fees paid translate into such advantages as infor-
believe it is still worth it. There is no free lunch. The whole
mation access, saved time, professional assessment of funds,
issue is as complex as it is because the strategies are dynam-
and ongoing oversight.
ic and unorthodox and the opportunities to benefit from these
things can be substantial. As can be the losses. If you can not
However, you must work out whether to trust the advisor!
put in the time, do not make the investment.
Sadly, the process of selecting a fund of funds advisor is similar to that for the selection of a hedge fund. An investor in a
Conclusion
fund of funds must understand and evaluate the advisor’s
Some hedge fund strategies are excellent for diversification and
approach to fund selection, portfolio construction, and opera-
for excellent return. But the main driver is the specific manager,
tional supervision.
not the strategy. If you can not evaluate the manager, then this
is not an investment strategy that you should pursue. And eval-
Fund selection
uating the manager involves much more than reading offering
■ Does the advisor perform the individual fund due diligence
documents or listening to a charming salesman.
process outlined above with adequate rigor? Does the
advisor make sure that the performance of the hedge funds
References
has been analyzed and that this performance is
• Amenc N. and L. Martellini, 2002, The Brave New World of Hedge Fund Indices,
working paper,
• Barr A., 2003, For hedge fund industry 2002 will be record year for failure, Bloomberg
• Botteron, P. and R. Villiger, 2003, Risks in hedge funds investments: the Swiss
perspective, forthcoming in Reader
• Cross Border Capital, The Young Ones, 2001
• Ineichen, A., 2002, ‘Funds of Hedge Funds: Industry Overview,’
The journal of wealth management.
• Lazard, Alternative Asset Strategies: Early Performance in Hedge Fund Managers,
2001
• Lhabitant, F.S., Hedge Funds, Myths and Limits, John Wiley & sons, LTD, 2002
• Fung W. and D. Hsieh, 2000, ‘Performance Characteristics of Hedge Funds and CTA
• Funds: Natural Versus Spurious Biases’, Journal of Financial and Quantitative
Analysis, 10:3, 291-307
• TASS Investment Research Ltd. and Tremont Partners, Inc., 2001, The Case For Hedge
Funds, 2nd Edition
continuously monitored using risk models?
■ Does the advisor provide access to otherwise desirable
funds closed to new investment? An analysis of the average
age of the portfolio of a fund of hedge funds will provide a
good indication of its ability to enter into closed hedge funds.
Portfolio construction
■ Does the fund of funds portfolio improve the risk return
trade-off of the investor’s existing portfolio? Who will do the
analytical work to confirm this using real investor data?
65
Risks
Shadow accounting:
The evolving practice
of exercising due
diligence in
fund reporting
Carol R. Kaufman
President, InvesTier operating unit of SunGard
Investment Management Systems, Inc.
Abstract
As alternative investment strategies gained increasing acceptance, the past couple of years turned into boom years for
hedge funds and funds-of-hedge-funds, bringing increased
visibility to the entire industry. But under that spotlight, when
mis-steps involving back office operational risk and the independence of net asset valuations drew the scrutiny of regulators and the media, a new trend emerged. In an effort to focus
on core competencies, reduce liabilities in peripheral areas of
their operations, and along the way achieve cost efficiencies,
many in the industry turned to outsourcing. For CFOs, this new
trend was anything but an excuse to wash their hands of some
aspects of operations – it was a catalyst for a fast rise in complexity of a practice known as shadow accounting. This article
explores the fiduciary responsibilities that compel funds to
employ shadow accounting, the added layers of control over
different facets of the organization that are gained from this
practice, and the data and technology requirements that different hedge funds or funds-of-hedge-funds may require as
they strive toward due diligence through this method.
67
Shadow accounting:
The evolving practice of exercising due diligence in fund reporting
Shadow accounting has become a frequent topic of conversation among CFOs at many hedge funds and funds-of-funds. For
CFOs this topic has progressed step-in-step with the rise of
outsourcing, which was spurred by the desire for independent
valuations and cost efficiencies as well as the burdens of
Sarbanes-Oxley certifications, investor demands for interim
■ Ensuring that the trades it made or were made on its behalf
were accurately executed and valued.
■ Ensuring that the results calculated and reported by
managers or administrators are accurate.
■ Evaluating reported results of underlying managers in
which a fund-of-hedge-funds firm is invested.
reporting, and regulatory reporting pressures. Shadow
accounting can be generally defined as the independent
In years past, when traders and managers began to outsource
crosschecking and confirmation of various aspects of account-
various functions of their back offices to third-party adminis-
ing functions being performed on a manager’s behalf. It can
trators, especially offshore administrators, a number of man-
encompass independent individual trade processing and valu-
agers became concerned about the slowness of reporting and
ation, fund NAV calculations and investor holdings, risk mana-
even the accuracy of the numbers, due to the time lags
gement reporting, and everything in between.
between when the administrators received the data from the
brokers and managers and when the numbers were finalized.
Although the term is relatively new, shadow accounting has
Investors would call frequently, soon after month-end, for
been practiced for as long as traders have been trading. In the
monthly performance information that some administrators
1960’s and 1970’s, traders frequently maintained their own
generally provided many weeks or, unfortunately even
personal blotter in elaborate manual spreadsheets used to
months, after month-end. Consequently, managers would
verify positions held at prime brokers and other places where
reproduce the offshore work, both to provide timely fund esti-
trading was being done, independent of their firm’s own
mates to their investors and to confirm the accuracy of the
accounting systems.
numbers being reported by the administrators they hired.
Later, in the early 1980’s, computerized spreadsheets and
Most recently, shadow accounting has evolved to encompass
portfolio accounting systems were created to process the
every aspect of accounting, including monitoring investor
trades and perform the independent crosschecks against the
holdings as well as underlying outside investment holdings
brokers with whom traders executed trades. Today, many
and valuations. Much of this expanded review process is due to
traders, hedge fund managers, fund-of-fund managers, pen-
increased visibility, regulatory accountability, external investor
sions and endowment funds, and corporations practice some
pressures, and other industry requirements and responsibili-
form of shadow accounting.
ties placed upon firms, including:
The case for shadow accounting
■ Aggregation of data - As it has become more common for a
There are a variety of reasons firms perform shadow account-
manager to allocate a fund’s business across multiple prime
ing, but in many cases they stem from a firm’s recognition of
brokers and to use different administrators across its funds,
its fiduciary responsibility. Even though it may outsource a
to obtain a true picture of one’s book of business, and risk
portion or all of its back office or rely on reports from prime
exposure, a firm has to aggregate the information
brokers or administrators, inherently an investment manager
generated from these multiple sources for risk analysis of
or fund manager trading other people’s money retains the ulti-
total holdings, performance consistency analysis, and
mate responsibility to its investors for:
reporting. If a firm is shadow accounting, regardless of the
number of brokers or firms they use, their internal process
provides the inherent aggregation they need.
68 - The
Shadow accounting:
■ Due diligence and contingency planning - With certain
these sometimes complex calculations, or if a firm uses
SEC and CFTC regulatory mandates incorporated into the
multiple outsourcers and selling agent carve-outs are based
2003 Federal Register relating to the continuity of a firm’s
on aggregated assets raised.
business in the event of a future significant business
disruption and with the NASD proposing more changes,
At its most basic level, a firm’s adoption of shadow accounting
pursuant to Section 19(b)(1) of the Securities Exchange Act
consists of reasonability and spot checking, possibly incorpo-
of 1934, firms have found that, as part of their operations
rating spreadsheet calculations that reproduce certain NAV or
plan, they should have certain contingency plans in place,
fee calculations. At the other end of the spectrum, shadow
such as the ability to switch providers at a moment’s notice,
accounting includes the actual reprocessing of certain por-
having pertinent information at hand without having to ask
tions of the firm’s or fund’s book of business, such as daily val-
an outside provider to prepare an ad hoc special report, and
uations, fee calculations, even performance table results. The
even self-sufficient backup if one or more of the providers
shadow accounting may be performed internally; there are
fail to deliver. An additional strategy is, of course, to
also vendors – that to date have marketed their services to
maintain a competitive environment to ensure the best
private wealth family offices – that offer some level of shadow
execution, commissions, services, and cost structure for the
accounting to confirm the results provided by other outside
firm and its funds.
providers.
■ Availability of detailed data for interim reporting and
The frequency of these operations varies, based on the firm,
additional, critical internal research - With heightened
the function, and even the level of risk associated with the
awareness and focus on operational risk of market
function. NAV recalculation might be monthly, bi-monthly, or
movements, there is an increasing need or desire for
even daily. Independent price checking against managers can
information to perform interim valuations or performance
be as frequent as weekly.
calculations more frequently (e.g., ad hoc, weekly, or daily)
than the contracted periodic reporting of such information
Although the initial reaction to these processes is that it is a
from one’s administrator or outsourcer. This might include
duplication of effort, shadow accounting can actually head off
holdings, trades or pricing/valuations with which to evaluate
potential back office operational risk. Divergent results can
price and strategy drift, comparative performance, and
flag misinterpretations and reduce the time in identifying dis-
proactive analytics. By having the data internally, firms can
crepancies early on, before they impact performance, NAV,
perform those additional valuations, what-if scenarios and
and reporting. Offering memorandums that set forth the rules
analytics to help them monitor their market exposure and
of a fund can be vague and open to interpretation. The imple-
properly react in a timely manner to market changes.
mentation of those rules can impact performance calculations, fee calculations, and allocation methodologies, resulting
■ Ability to process and provide adjunct information -
in accounting and legal implications.
Some firms utilize third parties, such as selling agents, to
bring in investors. The selling agents can be incentivized a
Focus: funds-of-hedge-funds (FOFs)
number of ways - by carve-outs, or sharing, of fees or by
Notably, the practice of shadow accounting has taken hold
receiving a trail based on the percentage of assets brought
among FOF managers, who inherently create an additional
in. These calculations may be outside of the scope of the
layer between the hedge funds in which they invest and the
services that outsourcers may be providing to the firm, for
outsourcer upon whom they rely to provide results. Since FOF
a variety of reasons, including lack of tools that can do
managers are generally disconnected from the underlying
69
Shadow accounting:
trading, additional information can become necessary for
Coordination of efforts with the firms a hedge fund or FOF
them to make informed decisions. Transparency debates are
uses is key. It is one thing for prime brokers, third party admin-
increasing in intensity, from both the perspectives of FOFs
istrators, and hedge funds to allow their processed data, such
managers seeking to ensure that their underlying funds follow
as investor capital transactions and investments, to be down-
their stated investment strategies and hedge fund managers
loaded into external hedge funds, pricing data, and even
protecting their proprietary trading models. The gamut runs
underlying open trade positions; it is another to be certain
from hedge fund managers refusing to provide detailed trade
that data can be synchronized and reconciled, and that there
information, to some allowing only risk parameters and peri-
is an agreed upon plan when discrepancies occur.
odic ‘snapshots’ to others embracing the concept, at least for
select investors. On the other side, some FOF managers will
If a hedge fund or FOF works with two or more firms from
not invest with managers that refuse to offer transparency,
which it wants to obtain data, it is important to consider
while others feel that volumes of trade information are not
import and export approaches that ensure the consistency
necessary to their due diligence. Some FOF managers feel that
and segregation of data, but still allow a firm to internally
the key to proper investment due diligence for their clients is
aggregate data.
through review and evaluation at a higher level of aggregation
of the underlying managers’ data.
In this light, it is critical to understand the difference between
interface and integration. An interface is a one-directional
The complexities of both strategies and structures dynamically
data flow. Integration describes a bi-directional data flow, with
change the process that the FOF’s manager can use to be able
built-in synchronization and automated reconciliation. An inte-
to evaluate and monitor operational risk of both underlying
grated solution is strongly preferable, to avoid synchroniza-
managers and external administrators. From small, growing
tion and reconciliation issues with the other parties with which
FOF firms to international, well established ones, shadow
the firm will send and receive data.
accounting is setting a standard: Mark Graham, Managing
Partner of Blue Advisers, a new, U.S.$ 100 million FOF firm,
With this in mind, when setting up a shadow accounting envi-
feels that ‘shadow accounting is part of the service we provide
ronment, the firm should strive to find a product or suite of
to our investors. It operates as a crosscheck. We are running a
products that allow for an open database environment. Open
business and need the right financial controls in place for our
technology for easy importing and exporting should be a key
investors.’ Glenn P. Cummins, Managing Director and Chief
component when discussing shadow accounting. How much of
Financial Officer of Ivy Asset Management, reports that ‘Ivy
the process would a firm want to perform independently? It
Asset Management Corp. performs shadow accounting on its
would have to ensure that it and its partners don’t overwrite
funds as an additional internal control on the quality of the
each other’s data. The best architecture incorporates a cen-
data being reported to our investors. We view timely and accu-
tralized data warehouse where many departments could tap
rate performance reporting as a key component of our client
into the same set of data. This allows the client services group,
services model.’
the research group, the investment managers, and the executives all to be looking at the same consistent set of data
Implementing shadow accounting
results.
There are a number of key factors hedge funds or FOFs must
70 - The
consider when implementing shadow accounting, factoring in
Functionality is also key. CFOs should consider what they want
their specific situation (one or multiple outsourcers or prime
to do now, but also consider possibilities down the road. Is the
brokers), their budget, their staffing, and their ability to imple-
system solution under consideration a scalable one? Does it
ment and maintain their stated plan.
provide for adjusting the level of shadow accounting being
Shadow accounting:
performed (the fund may want to take on more – or less – of
need or desire for information to perform valuations more fre-
the responsibility in the future, without requiring a major con-
quently than the contracted periodic reporting with adminis-
version of data). The questions below are useful in evaluating
trators or outsourcers. To implement shadow accounting,
a proposed software solution:
firms must coordinate efforts with the prime brokers and
other partners they work with and ensure a plan is in place for
■ What functionality does the fund need now and what might
when discrepancies occur. For a shadow accounting imple-
it want in the future? (e.g., tax, accounting, portfolio
mentation to be successful, firms should employ a bi-direc-
management, risk management, investor accounting,
tional import and export approach for exchanging data and
salesman tiebacks)
carefully evaluate the functionality, scalability, and flexibility
■ How comprehensive is the proposed solution? Does it
of the shadow accounting system they employ.
support all investment products?
■ Is it scalable? Can a hedge fund start out with reduced
To assess whether shadow accounting is really necessary,
functionality and increase it as it finds you need more?
firms must carefully consider their situations and philoso-
■ How quickly does it adapt when new products or tax
consequences are introduced that need to be incorporated?
■ How flexible is it? Can it handle complex calculations and
structures? Can it be customized?
■ Is it fully integrated? Is it necessary to input data more
than once?
■ How accessible is it? Can you get to your data 24 hours/day,
7 days/week?
phies: Are confirmations of certain accounting functions performed on the firm’s behalf viewed as important elements in
complying with the firm’s fiduciary responsibility? Does the
firm face situations where information – whether for decision
support, due diligence, or responding to investors or regulators – is maintained outside the firm and is not immediately
available? Does the use of multiple outside providers (e.g.,
prime brokers, administrators, etc.) require the firm to manu-
■ How user-friendly is it? Is there a support hotline?
ally aggregate data into useful information? Firms answering
■ How reliable is it? How long has it been on the market?
yes to any of these questions have rightfully confirmed the
■ How secure is it? Are there backup procedures?
heightened interest surrounding shadow accounting and make
User security levels?
this practice worthy of consideration.
■ What is the delivery mechanism? In-house? ASP model?
Outsourced? Can the client try it first? Switch from one
service level or another? Lease it? All of the above?
References
•
Conclusion
At its most basic level, shadow accounting allows firms to
ensure that the trades they made or were made on their
NASD Rulemaking: Release No. 48503; File No. SR-NASD-2002-108 (Notice of Filing
of Amendment Nos. 4 and 5 to a Proposed Rule Change by the National Association
of Securities Dealers, Inc. Relating to Business Continuity Plans and Emergency
Contact Information) September 17, 2003 Pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (‘Act’)1 and Rule 19b-4 thereunder.
behalf were accurately executed and valued. For managers
who use different administrators and allocate a fund’s business across multiple prime brokers, shadow accounting can
aggregate data from these multiple partners. Consequently,
fund-of -funds managers, who by definition have an additional layer between the funds in which they invest and the outsourcer who provides them with results have taken particular
interest in shadow accounting. As awareness of the operational risk of market movements grows, there is an increasing
71
Opportunities
An E.U.-wide passport for hedge funds
A single market for hedge funds
Marketing of hedge funds in Switzerland
Hedge funds in Asia
Key findings of the Edhec ‘European alternative
multi-management practices’ survey
An E.U.-wide passport for hedge
funds
John Purvis
Member of the European Parliament, and Vice-President of
the Economic and Monetary Affairs Committee
On 5 June 2003 the President of the European Parliament
Despite the difficulties involved in developing an all-encom-
announced that the Committee on Economic and Monetary
passing description of a hedge fund, certain characteristics
Affairs had been authorized to draw up an own-initiative
are common to all. These include:
report under Rule 163 on the future of hedge funds and
derivatives. The committee considered the draft report at its
meetings of 10 September, 4 November, 25 November, and 2
December 2003; and on 15 January 2004 the parliament
passed the new proposals to introduce an E.U.-wide passport
■ A legal structure in the form of private partnerships or
investment corporations.
■ Offshore location, usually in low tax and low regulatory
regime havens.
for hedge funds. This paper provides an overview of the dis-
■ Performance related fees.
cussions that were put forward in order to achieve such an
■ Freedom to use a variety of investment techniques to
approval.
enhance returns and/or to reduce risk.
■ Limited to rich and sophisticated investors.
What are hedge funds?
■ A goal of absolute returns.
A W Jones established the first hedge fund in 1949 by combining two risky types of investment - short selling and leverage
Hedge funds can also be loosely described according to their
– in order to limit overall exposure to market risk. The fund was
investment strategies. The primary investment categories
‘hedged’ because he held both stocks, purchased with bor-
identified by Tremont/TASS are:
rowed money, that would gain if the market went up, and short
positions, that would benefit if the market went down. He also
Long/short equity - Investing on both the long and short side
made the manager's fee a percentage of the profits (20% in
of the market so as not to be market neutral.
his case) and committed his own investment capital to the
Convertible arbitrage - Taking a long position on a convertible
fund.
security and a short position on its common stock.
Event driven - Profit from a corporate event (e.g. a merger).
The market has experienced dramatic growth since then.
Equity market neutral - Exploit inefficiencies in the equity
Today, assets under management are estimated to be between
market and minimise market risk.
U.S.$ 450 billion and U.S.$ 600 billion and in 2001 there were
Global macro - Profit from major economic trends or events.
446 hedge funds managed in Europe, although this repre-
Fixed income arbitrage - Profit from arbitrage opportunities
sented only 15% of the global total of hedge fund assets1.
in fixed interest securities.
During the same period, the variety and complexity of these
Dedicated short bias - Invest mainly in short positions in equi-
investment pools has also experienced explosive growth, mak-
ties and equity derivative products.
ing it increasingly difficult to accurately define exactly what
Emerging markets - Exploit inefficiencies and poor informa-
they are.
tion in immature markets.
Managed futures - Trade in listed financial and commodity
In 1999, the U.S. President's Working Group on Financial
futures markets.
Markets defined a hedge fund as ‘any pooled investment vehicle
Funds of funds - Invest in multiple hedge funds with different
that is privately organized, administered by professional
investment styles.
investment managers, and not widely available to the public’.
But the U.K.'s Financial Services Authority has declined to
We recommend that since the term ‘hedge funds’ covers such a
define the term, on the grounds that there is no identifiable
wide range of financial products, it might be more appropriate to
commonality.
call them ‘sophisticated alternative investment vehicles’ (SAIVs).
1
74
PricewaterhouseCoopers (May 2003).
Hedge funds in Europe
priate regulatory home for other alternative investment
Until recently, hedge fund investors were usually ‘qualified’
funds, which do not necessarily pursue absolute returns, in
individuals, who understood and accepted the inherent risks.
areas such as property, currencies, or commodities, and which
In the last two to three years, however, there have been many
are beginning to enter the European market but are currently
new entrants, including small outfits run by former long-only
unable to take advantage of a single, E.U.-wide regime.
asset managers. Pension funds and insurance companies are
now becoming significant participants.
Growing interest from retail investors suggests that we should
try and ensure that hedge funds are domiciled in Europe
Since Switzerland, Luxembourg, Italy, Ireland, and Hong Kong
where they could be better supervised. After all, certain hedge
eased regulations to make them more accessible to main-
funds may be directly accessible to retail investors anyway,
stream investors1, funds-of-funds have also experienced dra-
without any specific protection, via European market listings
matic growth in Europe. The German legislature is currently
or third country jurisdictions, or indirectly via funds-of-funds,
considering its own regulatory proposals. And although the
which provide diversified entry to the sector, or structured
U.K. recently decided not to relax its regulations3, Ireland has
notes.
been perhaps the most active in broadening access to hedge
funds. In December 2002 the central bank of Ireland allowed
As the Financial Services Action Plan nears completion, it is
registered funds-of-funds to invest entirely in unregulated
appropriate for the Commission to turn its attention to what
schemes, provided there is a minimum investment of €12,500,
would be a suitable legislative accommodation for hedge
the fund manager has appropriate expertise, and the fund
funds and other sophisticated alternative investment vehicles
does not invest in other funds-of-funds. (Previously, retail
that currently lack a European regulatory home. In order to
investors could only access funds-of-funds that invested less
achieve this objective, the European parliament needed to
than 10% of net assets in unregulated funds.) The UCITS direc-
consider and debate a number of issues.
tives permit funds-of-funds to invest up to 30% of their assets
in ‘other collective investment undertakings’, including hedge
The areas of debate
funds, as long as they meet standards equivalent to the rele-
■ The marketplace for hedge funds is fragmented due to
vant directives3.
varying regulatory regimes, a lack of consistent platforms,
and discriminatory tax administrations. Institutional and
Despite all these developments, the current regulatory and fis-
private investors are showing increasing interest, but lack
cal conditions in the E.U. have discouraged the growth of an
suitable vehicles in E.U. jurisdictions. We feel that a sepa
active hedge fund market within E.U. jurisdictions. Discrimina-
rate, lightly regulated regime would be the best option.
tory taxes and regulations in some member states have held
Funds would elect to be regulated under this regime and
back potential investment in foreign domiciled hedge funds,
would be required to adhere to its particular rules.
including those in other member states. As a result, these
vehicles are mostly domiciled offshore.
■ There is concern about allowing hedge funds to be sold to
retail investors without clear disclosure of trading
strategies, performance fees, performance reporting,
Success in attracting SAIVs onshore depends on establishing a
financial transparency, and certainty of pricing. It is clear
lighter regulatory regime than for conventional UCITS. This
that such products must have a very transparent and
regime should concentrate on provision of sufficient and intel-
well-understood health warning as well as a fully
ligible information to the investor rather than on over-pre-
comprehensible description of their style and risk profiles,
scriptive rules and regulations. SAIVs could provide an appro-
including their fee structures.
2 Financial Times, July 31, 2003, Thursday U.S. Edition 2.
3 In the U.S., concern about hedge funds has prompted a report by the staff of the
Securities and Exchange Commission, which recommends more explicit means of
regulation and registration of participants.
4 Directives 2001/107/EC and 2001/108/EC of the European Parliament and of the
Council of 21 January 2002 amending Council Directive 85/611/EEC.
75
■ There is concern about the systemic impact that hedge
funds might have on financial markets via market,
2005 and suggests, given the potential for systemic risk as
well as the increased interest in the general investor
operational, and credit risk. Regulators and banking
community; that this should be brought much further forward.
supervisors should develop means of assessing and
■ Given the fact that many hedge funds operate offshore and
exchanging information about the extent of any such
are not subject to E.U. regulation, calls on the European
accumulated systemic risks.
Commission to introduce legislation to make lending by E.U.
■ Hedge funds can be high risk if there is inadequate internal
financial institutions to offshore hedge funds more
risk control. Less habitual participants, such as corporates
transparent; Feels it is opportune to facilitate access to
and individuals, may be less able to deal with them, and
SAIVs for the moderately affluent investor and, in due
thus vulnerable to unforeseen and unsustainable losses.
course, when the different regulatory authorities at
The accounting regulators should be implementing, in the
European level recommend it is appropriate, the retail
context of internationally accepted accounting standards
investor; and that regulated funds of hedge funds could
(e.g. the International Accounting Standards Board) and
internal audit controls, a compulsory reporting system for
play a vital role in this gradual process.
■ Considers it timely to develop a light-handed and
all company accounts. For individuals, the only safeguard is
appropriate E.U.-wide regulatory regime for SAIVs that will
recourse to education and some degree of protective
help attract them to locate in the E.U. and provide the
regulation related to the extent of their knowledge, wealth,
benefits of a common European passport by means of
and sophistication.
■ Regulators may have difficulty assessing risk and keeping
mutual recognition.
■ Points out that a regulatory regime for SAIVs must be
up with fast-moving developments. They may not always be
liberal enough not to negate their role as an alternative
aware of the exposure of the international financial system
investment medium of choice or impede the freedom of
as a whole. For the time being we would tend to favor
investment managers (inter alia) to:
co-ordination by national regulators rather than by an E.U.
• employ innovative and even exotic techniques and
regulator. These will need to have staff with the expertise
adequate to fulfill this rather exacting role in a fast-moving
and technically shifting area of finance.
■ Some argue that hedge funds contributed to recent market
instruments.
• take strong positions, including by the use of shorting,
leverage, and derivatives.
• be remunerated relative to their performance.
volatility; others say that they contribute to market stabili
Provided that their investment and operating methods are
ty. On balance, we feel that hedge funds contribute to the
disclosed in appropriate terms to those who invest with
efficiency and self-balancing of financial markets and that a
light regulatory regime in a free-flowing global market with
near-harmonized basic rules would be the best option.
them, directly or indirectly.
■ Considers that the regulator must verify and be satisfied
that the promoters, directors, and managers of a SAIV are
fit and proper persons to be entrusted with responsibility
Based on the above, we made the following recommendations
for the savings and investment funds of third parties and
to the European Commission.
are adequately expert and well-informed in the investment
techniques and instruments employed in that undertaking;
76 - The
The committee:
further that the risks inherent in any SAIV are clearly
■ Reminds the Commission that Final Article 2 of Directive
advertised and communicated to investors, that the
2001/108/EC, requested preparation of a comprehensive
advertised style of investment and level of risk are not
report on this area of investment practice by 13 February
exceeded, and that risk is properly monitored and controlled.
■ Stresses that the SAIVs regime should concentrate most
particularly on the distribution and sales methods
employed, so as to avoid investment in them by persons for
whom they are inappropriate.
■ Considers that investment funds should be able to elect to
the Lamfalussy Process and that the detailed requirements
be decided and regularly reviewed at level 2 but subject to
Parliamentary scrutiny and call back.
■ Calls on the Commission to consider whether a regime for
SAIVs should be enacted as a distinct part of a revised
be regulated under the UCITS or the SAIVs regime and be
UCITS directive or in a separate directive and considers that
bound by that regime's requirements.
any such regime should cover hedge funds and other
■ Urges the investment industry and national regulators to
sponsor campaigns to educate potential investors about
SAIVs, their characteristics, and their risks.
■ Considers it most desirable that distributors should be
alternative investment funds.
■ Considers that the world's supervisory authorities should
develop an effective means, possibly including a centralized
credit register at the Bank for International Settlements as
specifically authorized to distribute SAIVs and that such
proposed by the Financial Stability Forum of April 2000, to
authorization should depend on their probity and level of
monitor and control the extent of credit, management, and
knowledge regarding SAIV products and be renewable on a
operational risk that this sector could bring to the world's
regular schedule.
financial system and urges the Commission to instigate
■ Considers it essential to provide individuals investing in
SAIVs with a clear and simple risk description and warning
to be acknowledged by them as representing their
understanding of the risks involved.
■ Encourages the industry to develop a self-regulatory code
such a mechanism, which should also include the more
effective enforcement of existing provisions.
■ Calls on the Commission, in conjunction with national
regulators, to investigate the practice (predominantly by
American arbitrage hedge funds) to use time zone
of conduct that encompasses aspects not expressly
differences and the influence of Wall Street on other
covered in the formal regime and in particular regarding
markets to profit by market timing Asian and European
appropriate sales and distribution methods.
mutual funds, and to determine whether this significantly
■ Accepts that a minimum limit might be imposed on
investments into such funds while public understanding is
poor but that this should be progressively reduced and
ultimately eliminated as awareness improves.
■ Suggests that it should be permitted for SAIVs, which have
long-term investment horizons, to restrict the duration of
windows for sales, redemptions, dealings, and net asset
valuations.
■ Considers that SAIVs should be required to run rigorous
harms long-term investors in those funds and whether any
steps need to be taken to rectify the situation.
■ Expects the Commission to take action against member
states that, by means of differential taxation, additional
regulatory requirements or other methods, discriminate
against SAIVs domiciled in other member states.
■ Urges the Commission to consult with the legislative and
regulatory authorities in the U.S., Japan, Switzerland, and
other relevant jurisdictions with the aim of developing as
daily risk controls so as to ensure that they stay within their
consistent an approach as possible internationally in this
advertised risk parameters.
area of investment, to report on implementation in the
■ Urges the industry, in consultation with the regulatory
different member states and in third countries of the
authorities, to develop easily understood and consistent
recommendations of the Financial Stability Forum, in
risk measurements or indices, which should be published
particular in regards to hedge funds and the regulation of
regularly to indicate to investors that advertised risk limits
offshore centres, and to indicate what steps it intends to
are being observed.
take with a view to the introduction of essential regulations
■ Urges that an E.U. regulatory regime for SAIVs come within
at the international level.
77
Conclusion
This report on hedge funds (or SAIVs) was an initiative of the
European Parliament. It obtained a very large majority of 344
to 69. The next stop is likely to be for the European
Commission to come forward with draft legislation in order to
give effect to this initiative. With the imminent European
Parliament elections (10 June) and the change of Commission
(November), this may be delayed until early 2005. However,
there is growing pressure from the investing public, from market practitioners who see a business opportunity, and from
regulators. Furthermore certain E.U. countries (Ireland,
Germany, and Luxembourg) are already bringing forward
national regimes to permit the setting up of hedge funds.
I believe that the Parliament's resolution gives a viable blueprint for development of this business within E.U. jurisdictions.
I hope it will be taken forward without undue delay.
78 - The
79
A single market for hedge funds
Wolfgang Mansfeld
President, FEFSI
In the past decade significant progress has been made in
Despite popular criticism of Brussels-rulemaking, the UCITS
achieving a single European market for investment funds. The
Directive has become a world-wide recognized model for fund
ratio of cross-border fund flows has reached an estimated
regulation providing a high level of investor protection. It is
level of more than 20%, and in some European countries the
this investor protection that has helped the strongly-develop-
number of registered non-domestic investment funds exceeds
ing European investment fund industry to preserve its integrity
that of domestic funds. These are important achievements for
and encouraged investor confidence.
the industry. A true single market in the fund business is not
just ‘nice to have’. Only an enlarged and unified single market
The hedge funds challenge
will allow the industry to achieve economies of scale. Today,
Not all investment funds are harmonized UCITS benefiting
the average fund size in the U.S. is six times that of Europe.
from the single market framework and the passport for going
cross-border. Outside this Directive, member states allow
The same is true for economies of scope. 25,000 funds in
other types of investment funds in their jurisdictions.
Europe do not reflect variety in offers but duplication of
product types. The evolution of business models will depend to
Unfortunately, among these ‘non-harmonized’ investment
some degree on the single market, e.g. the larger and more
funds there are obviously some fund types that are innovative
integrated the market the better the opportunities for niche
and increasingly popular. Real estate funds are one example,
providers.
hedge funds another. The case of hedge funds demonstrates
that the single market approach – despite the merits of the
The UCITS success
UCITS Directive – needs an overhaul.
To a large extent, the progress towards the single market can
be attributed to the European regulatory framework for
Hedge funds differ from traditional investment funds in vari-
investment funds - the so-called UCITS Directive, which aims
ous aspects. They use a wide range of investment techniques
at approximating conditions of competition, ensuring effective
and instruments, in particular derivatives; they do not follow
investor protection, and simplifying cross-border marketing.
general stock and bond market trends, but seek absolute
return and aim at limiting downside risks.
The UCITS Directive is based on three principles:
■ Minimal harmonization of national legislation regarding
That sounds good, particularly after the recent bear market
investment funds.
years. It explains why hedge funds – and in particular funds of
■ Mutual recognition.
hedge funds as the more diversified version – have become
■ Home-country control.
increasingly retailized. That means that they are increasingly
marketed to a broader segment of private clients.
The Directive only covers the products which comply with
certain standards, e.g. redemption at net asset value at the
Hedge funds have traditionally been based in offshore juris-
holder’s request, investing in transferable securities and other
dictions and are regulated loosely. Retailization, however,
eligible assets, operating on the principle of risk-spreading,
means more explicit regulation. Both are two sides of the
and entrusting their assets to a depositary. UCITS investment
same coin. This is why countries with large domestic markets
funds, which fulfill these requirements, can be marketed freely
– such as Italy, France, and Germany - have recently introduced
across borders in Europe without further permission. They
hedge fund regulations in order to support a guided retailiza-
only need to be registered in the host country.
tion and create a framework for domestic production of hedge
funds (traditionally produced offshore).
80 - The
The critical point is that although national regulations strive
amend an EC directive may take years; it is too lengthy a
for the same goals, they differ significantly in structure. Some
process to keep up with developments in the industry creation.
examples:
By the time the process is concluded the rules could once
again lag behind the state of product innovation.
■ In Germany and France, hedge funds may be managed by
UCITS fund companies. In Italy a separate management
What is required is faster and more flexible rule-making pro-
company is required.
cedures. Legislators and the fund industry should concentrate
■ In Luxembourg and France, hedge funds are subject to
on solutions in this area.
restrictions on the product side, regarding borrowing and
short sales, whereas in Germany and Italy no such
One idea certainly worthy of consideration is the so-called
restrictions exist.
Lamfalussy approach to EC legislation. It offers a more stream-
■ In Italy, high minimum investments are required. Germany
lined approach towards financial legislation, regulation, and
takes a different approach allowing fund of hedge funds to
supervision. The intended extension of this process to invest-
be marketed publicly. France separates retail, qualified, and
ment fund regulation could be the solution. The Lamfalussy
relatively informed investors, all requiring a different
structure is currently applied to securities legislation. A pro-
marketing approach.
posal by the EFC that has been endorsed by the ECOFIN
council proposes to extend this to banking and regulation –
The list could be extended. The differences have implications
and at the same time to include UCITS regulation in the secu-
on the cross-border marketing of hedge funds. As hedge funds
rities’ pillar. Thus, the merits of this approach (although prac-
are not harmonized, each country will allow the registration of
tical experience is rather slim so far) would be extended to the
foreign funds only if they comply by and large with its own
fund industry and the UCITS Directive.
national rules. This seems to be fair. However, due to the differences in national regimes requirements will vary signifi-
The European fund industry, therefore, has not hesitated to
cantly from country to country. A pan-European business
welcome this development as it might contribute to solve the
approach outside the restricted area of institutional place-
challenges it is currently facing.
ment is strongly discouraged, if not made impossible.
New ways forward
Is there a case for striving for a single market for hedge
funds? Certainly yes – a fragmented market in Europe will not
be a basis to build up competitive onshore production.
So what should happen? A new EC directive for hedge funds
as proposed recently by the European Parliament would not
be a good solution – one fund directive (UCITS) is sufficient. So
why not extend the UCITS Directive and its well-established
principles of harmonization and single market creation to
hedge funds and all other future innovations?
Past experience has shown that the process to create or
81
Marketing of hedge funds
in Switzerland
Shelby R. du Pasquier
Partner, Lenz & Staehelin, Geneva
In the last few years, alternative investments and hedge funds
Legal and regulatory framework
in particular have become part of the standard asset alloca-
The relevant legal framework as regards to hedge funds is the
tion process in the Swiss private banking business as well as
Swiss Mutual Fund Act of March 18, 1994 (the Act). The Act
for many Swiss institutional investors. This is the case even
sets out a framework governing the setting up of Swiss mutual
though, given legal and regulatory constraints, hedge funds
funds and the promotion of non-Swiss collective investment
may only be distributed in Switzerland by way of private place-
schemes in Switzerland. It has been implemented by a series
ment, without any public offering. In addition, Swiss law and
of ordinances issued by the Swiss federal executive, the
the practice of the supervisory authority, the Federal Banking
Federal Council, and the Swiss supervisory authority for mutual
Commission, allow for the setting up and the public distribu-
funds, namely the Federal Banking Commission (FBC). The
tion of collective investment schemes which take different
FBC has further issued a series of circulars and published a
forms and which invest into hedge funds (e.g. investment com-
number of decisions in the area of mutual funds. In particular,
panies, investment foundations, and funds of hedge funds).
in May 2003 it issued an important circular dealing with the
These structures have also contributed to the success of alter-
public offering of non-Swiss mutual funds, which is very impor-
native investments in Switzerland. For the rest, the on-going
tant for the distribution of hedge funds in Switzerland (see
revision of the Swiss mutual fund legislation is expected to
below). It is also to be noted that the Act is currently being
create additional flexibility in regards to the offering of this
revised in order to broaden the scope and legal forms of reg-
type of investments to the Swiss market.
ulated collective investment schemes.
The Swiss market
Swiss collective investment structures
Switzerland is an important player in the alternative invest-
It may look paradoxical that in spite of the importance of
ment arena, especially for hedge funds. Although reliable sta-
Switzerland in the area of hedge funds, no Swiss hedge funds
tistics on this topic are difficult to come by, it is generally con-
have yet been created. The reasons for this are two-fold.
sidered that, after the U.S., Switzerland is the second-largest
Firstly, the Act only allows for the establishment of collective
market for hedge funds in the world.
investment schemes having a contractual form (i.e. fonds commun de placement – FCP). This in turn requires the existence
A number of factors have contributed to this situation. Firstly,
of a Swiss management company which needs to be licensed
Swiss private banking and its sophisticated clientele have been
by the FBC. Corporate schemes, which are the most common
among the first to invest in hedge funds, and to do so mas-
legal form for hedge funds, do not fall within the scope of the
sively. With the years, a number of Swiss banks and financial
Act. Also, the relevant legal and regulatory framework imposes
advisors have thus developed an expertise in alternative
relatively strict rules to Swiss funds, in particular with regards
investments. In parallel, Swiss institutional investors (e.g. pen-
to investment restrictions (e.g. prohibition of managed
sion funds) have been quick to include alternative investments
accounts, risk spreading rules, limited leverage, etc). These
in their asset allocation model. Recent changes in the applica-
rules conflict with the desire of hedge fund managers to
ble regulatory framework have further expanded the ability of
secure a maximum flexibility in the management of their
these Swiss investors to invest in hedge funds, or funds of
funds. Further, tax considerations are an obstacle to the set-
hedge funds.
ting up of a Swiss hedge fund. Thus, the Swiss Tax Administration considers Swiss mutual funds as transparent from a tax
point of view. This results in the Swiss residents holding units
in a Swiss collective investment scheme being taxed on the
income generated by the fund regardless of whether or not
82 - The
such income is distributed. This in practice is a problem for
Another type of Swiss investment scheme which is used in
hedge funds, as these structures are typically growth funds.
Switzerland is the investment foundation. Its features are
Further, Swiss collective investment schemes are subject to a
similar to those of a fund of hedge funds, although the invest-
35% withholding tax which is applied on any dividend income
ment foundation offers an enhanced level of corporate gover-
distribution made by the fund, or upon redemption of the fund
nance. The scheme is usually open-ended, the investors in an
units. Although part or all of this withholding tax may be
investment foundation having a right to redeem their interests.
refundable depending upon the country of residence of the
Furthermore, this structure is not governed by the Act, but by
unitholder, this is a major issue for investors who are not Swiss
the general rules contained in the Swiss Civil Code applicable
taxpayers, as is the case with most clients in the Swiss private
to foundations as well as by certain regulations applicable to
banking industry.
pension funds5. The supervision is made by the cantonal or
federal authority in charge of pension funds, depending upon
Notwithstanding the above, a number of structures have been
the scope of activities of the investment foundation6. In prac-
set up in Switzerland in an attempt to tap the appetite of the
tice, access to these schemes is limited to Swiss pension funds.
Swiss market for hedge funds. Thus, since 1996, the FBC has
allowed the setting up of Swiss funds of hedge funds1. These
Distribution issues
funds qualify as so-called high risk funds under the Act2. This
As indicated, the current legal and regulatory framework pre-
structure has become increasingly popular over the years.
cludes the setting up of Swiss hedge funds. As a result, fund
Thus, a number of Swiss funds of hedge funds have been regi-
promoters have looked into various ways to distribute their
stered with the FBC and are publicly offered in Switzerland3.
(offshore) hedge funds in Switzerland. In this context, it should
Another form of collective investment scheme which has been
be noted that, under the Act, the distribution of a hedge fund
used in Switzerland in the alternative investment area is the
is treated in the same manner as any other non-Swiss mutual
Swiss investment company. By its features, such a structure is
fund. Generally speaking, no professional offer of a mutual
close to a fund of hedge funds, with however a number of dif-
fund is allowed in or from Switzerland without the prior regis-
ferences. Typically, an investment company is set up as a Swiss
tration of the collective investment scheme with the FBC7. In
corporation whose shares are listed on the Swiss Exchange. As
practice, registration is, however, not an available option to
is the case for a fund of hedge funds, the investment company
hedge funds for two reasons. Firstly, registration is only avail-
invests (through an intermediary offshore holding company)
able to a non-Swiss fund to the extent it has been set up in a
into a portfolio of hedge funds. As opposed to a Swiss fund of
jurisdiction which offers a level of supervision and of investors'
hedge funds, such a structure is not regulated by the FBC or
protection which is comparable to the one offered by the Act8.
4
any other supervisory authority . It is, therefore, not subject to
This is, however, not the case concerning most jurisdictions
any regulatory constraints concerning its investment policy
where hedge funds are typically incorporated (e.g. Cayman
and restrictions, which may be freely decided in accordance
Islands, British Virgin Islands, etc.). Furthermore, the registra-
with its articles of incorporation and by-laws. Its creation and
tion of a non-Swiss fund presupposes its compliance with the
operation are therefore somewhat simplified. Also, the Swiss
investment restrictions (e.g. risk spreading, leverage limita-
investment company is by law closed ended, the investors
tion, etc.) which are applicable to Swiss collective investment
having no redemption right on their shares. In practice, this
schemes. As indicated, this constraint is usually a major issue
has often resulted in the creation of a discount of the share
for hedge fund promoters. In practice, it therefore precludes
price as compared to its net asset value. As a result, these
the public offering of hedge funds in or from Switzerland.
structures have now become much less popular than openended funds of hedge funds.
1 FBC 1996 annual report, 193.
2 Art. 35 (b) Act; Art. 44 of the implementing ordinance of October 19, 1994 (‘IO’)
3 As of December 31, 2003, 57 Swiss ‘high risk’ funds (including sub-funds within
one umbrella structure) have been registered with the FBC. Although no specific
breakdown exists, one can say that this figure includes a majority of funds of
hedge funds.
4 Art 3 (2) Act; FBC 1996 annual report, 194.
5 Art. 80 ss Swiss Civil Code; Arts 49 ss; 56 federal ordinance as regards
professional plan for old age, survivors and invalidity dated April 18, 1984 (OPP2)
6 At the federal level, the competent authority is the Federal Office for Social
Insurances (OFAS)
7 Art. 45 (1) Act
8 Art 45 (2) Act
83
In this context, it should be noted that the situation is marked-
ever, defined by the FBC over the years. This practice was
ly different for funds of hedge funds. These structures indeed
recently codified in a circular issued on May 28, 200312(the
do not face the same difficulties as hedge funds themselves.
Circular). In essence, this Circular formalizes the pre-existing
Indeed, funds-of-funds are often incorporated in jurisdictions
practice of the FBC, with certain changes.
which are deemed comparable by the FBC to the Swiss one,
such as Luxemburg, Ireland, Jersey, or Guernsey. Also, the
In substance, the Circular defines the public offering as com-
investment restrictions imposed by the FBC may usually be
prising any form of solicitation for the subscription of shares
complied with at the level of the fund of hedge funds. That
or units in a mutual fund, regardless of the type of media used
being said, the registration of a non-Swiss fund of hedge funds
for that solicitation (e.g. public advertisement, mass mailing,
remains a rather complex and lengthy process in as much as,
NAV publication, cold calling, roadshows, etc.). By contrast, a
similar to a Swiss fund of hedge funds, it constitutes a high risk
targeted offer to a limited number of investors remains
fund within the meaning of Swiss law. As a consequence, a fil-
allowed provided the number of investors contacted over a
ing with the FBC presupposes that a number of requirements
certain period of time (one year) is twenty or less. Also, the
be met by the fund, which have to do with the structure of the
Circular provides for an exemption for institutional investors
fund itself (e.g. ringfencing and local substance) as well as with
who may be contacted without any numerical limitation. The
the experience and qualifications of the fund management. As
concept of ‘institution’ is narrowly defined in the Circular so as
of December 31, 2003, 68 non-Swiss high risk funds, mainly
to include banks, securities dealers, fund management com-
from Luxemburg, were registered for public distribution in
panies, insurance companies, pension funds, as well as large
Switzerland9.
industrial or commercial groups. As opposed to the situation
prevailing in other jurisdictions, that definition specifically
To be complete, one should also note that in the recent years,
excludes independent financial advisors (IFAs) and high net
certain financial institutions have launched in the Swiss market
worth individuals (HNWI).
funds-linked notes, whose proceeds are invested into a portfolio
of hedge funds or, in certain instances, into one single hedge
Furthermore, the Circular contains specific rules which are
fund. Typically, the performance of the notes is linked to the
applicable to the promotion of unregistered funds by Swiss
underlying fund or portfolio of funds with generally a capital
financial institutions (e.g. banks and IFAs) within the context of
protection (upon maturity). For a while, the FBC has allowed
their asset management activities. These institutions may
the public distribution of this type of instrument in Switzer-
place unregistered funds in the portfolio of their managed
land provided they meet certain requirements having to do
clients. Thus, under the investment guidelines issued by the
with the capital protection and credit rating of the issuer (or
Swiss Bankers' Association (‘SBA’), a portion of the clients'
guarantor)10. More recently, the Swiss supervisory authority
assets may be invested into alternative investments for
has, however, taken a more restrictive stance and limited the
diversification purposes. This presupposes, however, that the
ability to publicly offer these instruments in Switzerland.
investments are structured as fund of funds or otherwise
guarantee a risk diversification, and offer liquidity (through a
redemption feature, for instance)13. On the other hand, finan-
Swiss private placement rules
As indicated, any public offering of a fund in or from
11
cial institutions are not allowed, as a rule, to generally offer
Switzerland triggers a registration duty with the FBC . By con-
unregistered funds to clients with whom they only have a cus-
trast, the private placement of a non-registered fund remains
todial or advisory relationship.
permitted. The notion of public offering or solicitation is not
defined by the Act or its implementing ordinances. It was, how-
84
9 The same remark as for Swiss funds applies (see n. 3)
10 FBC 1999 annual report, 214.
11 Art 45 (1) Act ; Art 1a IO
12 FBC-Circ 03/1-Public offering
13 Art. 12, 2003 SBA Portfolio Management Guidelines
Finally, the Circular contains specific rules dealing with the
offering of unregistered funds over the Internet. In this context, the FBC practice is somewhat liberal. To the extent a website is deemed to target Swiss investors based upon certain
criteria (e.g. language, use of Swiss contact or references,
etc.), certain steps need to be taken in order to comply with
the Circular. The steps include a specific disclaimer as to the
non-registration of the fund in Switzerland; this disclaimer
must appear on the site and needs to be acknowledged by
potential investors. The alternative is the setting-up of a system of passwords which effectively blocks the access by Swiss
residents to information relating to unregistered funds.
Conclusion
Alternative investments and hedge funds in particular are now
an integral part of the asset allocation process of Swiss asset
managers and institutional investors. The existing legal and
regulatory frameworks, as well as the practice of the Swiss
supervisory authority, have allowed that evolution. Certain difficulties however remain, in particular in view of the narrow
scope of the private placement rules and in the absence of any
exemptions for accredited investors. In this context, the ongoing revision of the Act is a welcome development as it
should improve the situation on both counts.
85
Opportunities
The hedge fund
revolution
R. McFall Lamm, Jr.
Chief Investment Strategist and Head of
Global Portfolio Management,
Deutsche Bank Private Wealth Management
Abstract
Over the last half decade, asset flows into hedge funds have
the status quo of plain-vanilla stock and bond investing, hedge
surged, the number of funds has expanded exponentially, and
funds have a theoretical advantage over traditional invest-
new products have emerged which allow investors to obtain
ment approaches, and maintain that the performance-based
hedge fund exposure via structured transactions. To many,
compensation system used by hedge funds aligns the manag-
this is due to a paradigm shift in investment management and
er’s interests with those of the investor to their mutual bene-
constitutes a modern financial revolution. However, to others,
fit. As a result, significant commitments to hedge funds are
hedge funds are simply investment strategies that do not even
appropriate for most investors. This should remain so, at least
merit consideration as an independent asset class. The oppo-
until that time when the paradigm shift is complete and the
nents of hedge fund investing argue that performance data
last of the traditionalists has accepted the advantages of
are misleading and that hedge funds exhibit large downside
hedge funds.
risk, lack transparency and liquidity, and are not tax efficient.
They assert that one should think long and hard before making any allocation to hedge funds whatsoever. In this article I
argue the contrary, making the case that hedge funds are the
best-performing asset class over the past decade and more,
and are likely to remain so in the near future. Furthermore, I
suggest that critics often have a vested interest in maintaining
87
Over the last half decade, investing in hedge funds has
$800
emerged as an intriguing and hotly debated subject. While
$700
Equity hedge/other
Sector
Fixed income
Relative value arbitrage
Merger arbitrage
Event-driven
Macro
$600
$400
$300
Although one can debate the merits of hedge funds, it cannot
$200
be denied that a fundamental structural transformation is
$100
such as specialized funds-of-funds, index funds, principal-
20
03
20
02
20
01
19
99
20
00
Furthermore, more complex hedge fund products are emerging,
19
98
19
97
19
96
19
95
$0
19
91
funds and a strong increase in the number of funds.
19
90
underway characterized by surging asset flows into hedge
19
94
urged caution.
$500
19
93
others, such as Lo, Anson, Kat, Lockoff, and Schumandine
Billion
aged investors to make substantial allocations to hedge funds,
19
92
some asset managers, such as Swensen and Lamm, encour-
Figure 1: Hedge fund assets under management
protected hedge funds, and structured products such as
swaps and options on underlying pools of hedge funds. Unlike
past revolutions in investment management, where the gene-
fund portfolios were generally no more risky than bond port-
sis was responding to changing institutional requirements,
folios1.
private investors are the primary motivators of the hedge fund
revolution.
The major shock that stimulated increased acceptance of
hedge funds was the dramatic equity market sell-off from
This article discusses the transition to the new investment
2000 to 2002. This event decimated investment portfolios
management paradigm, which admits hedge funds as a core
dominated by equity advocates lulled into Ponzi euphoria fol-
asset class. The first sections of the article review evidence of
lowing nearly two decades of rising stock prices. The resulting
the hedge fund revolution now underway, describe why it is
wealth destruction created a funding crisis for endowments,
occurring, and illustrate that hedge funds exhibit the best
pension funds, and trusts, as well as forcing lifestyle adjust-
returns of any asset. The following section highlights why
ments for many private investors.
hedge fund managers have a theoretical advantage over traditional asset managers. The subsequent sections describe
In response, many individuals and institutions began to reject
barriers to the paradigm shift, criticisms of hedge funds, the
the traditionalists’ mantra of limiting investments to stocks
asset allocation to hedge funds, and related topics. The major
and bonds, and began increasing their hedge fund allocations.
conclusion is that while the transformation process is well
Indeed, flows into hedge funds accelerated through the equity
underway, it has much further to go.
market crash (Figure 1) with estimates by Hedge Fund
Research (HFR) showing 7% growth in 2000, 9% in 2001, and
Evidence of the paradigm shift
16% in 2002. By the third quarter of 2003, HFR estimates that
Revolutions are upheavals that arise in response to system
hedge fund assets reached U.S.$ 687.5 billion, which would
shocks, often years after the intellectual foundations are laid.
represent another year of double-digit growth. While this
The hedge fund revolution currently underway is no exception
amount is still small relative to stock market capitalization, it
in this regard, with the virtues of hedge funds having been
represents an enormous gain from the early 1990s when
carefully enumerated in the late 1990s when new research
hedge funds were a negligible portion of invested assets.
demonstrated that, contrary to popular beliefs, balanced hedge
1
88 - The
In addition to Lamm and Swensen, the reader is referred to excellent surveys of
published work supporting hedge fund allocations by Schneeweis and Signer,
and Favre.
Unique characteristics of hedge funds
An additional aspect of performance-based compensation is
Strategy innovation
that it creates strong financial incentives for the best man-
Available data demonstrate that the hedge fund industry is
agers from the traditional asset management world to migrate
very dynamic. Strategies that deliver attractive returns today
to the hedge funds. This is simply because under a pay-
often fade in the future as opportunities evolve. For example,
for–performance system, such managers stand to be much
there was a dramatic transformation over the last decade
more richly rewarded than would be the case if they were paid
from a situation where global macro hedge funds predomina-
on a fixed-fee basis.
ted, to one where other strategies have become much more
prevalent. This was highlighted by George Soros’ fabled cur-
The hedge fund performance record
rency bet against the Bank of England in the early 1990s. After
The best returning asset
the sterling broke, most governments transitioned to floating
An examination of historical returns for hedge funds reveals
rate regimes and hedge fund trading in anticipation of devalu-
that they have significantly outperformed traditional assets
ations became less profitable. As a result, assets first migrated
from 1990, when reasonably reliable data first became avail-
to equity long/short hedge funds, and more recently to fixed
able (Figure 2). Indeed, the average annual return for hedge
income arbitrage, convertible arbitrage, distressed debt, and
funds from 1990 through the third quarter of 2003 was 13.2%.
other strategies, which emerged as the new deliverers of per-
This compares with 10.9% for stocks, 7.8% for bonds, and
formance.
4.7% for cash. This is true even if one takes a more conservative measure of hedge fund performance represented by a
This pattern of innovation in the hedge fund industry implies
fund-of-funds (FOF) index, which shows an average annual
the strategy mix is likely to look very different a half-decade
hedge fund return of 11.2% annually2.
from now as the global economy and new financial markets
evolve. This contrasts with traditional stock and bond invest-
Equally important is the fact that standard deviation (risk) of
ing, which essentially exhibits the same fundamental behavio-
returns for the hedge funds is only 6.1% over the sample and
ral characteristics over time.
5.5% for the FOF Index. This compares to 15.1% for stocks and
Downside risk protection
Another unique characteristic of hedge funds is that they pro-
$700
vide downside risk protection via performance-based compensation, which explicitly aligns the managers’ interests with
$600
those of the investor. That is, there is no performance fee if
$500
potential losses for the investor while passing through gains
proportionately. It forces hedge fund managers to be very
careful and is probably a primary reason why the hedge fund
S&P 500
Dec 1989 = $100
hedge fund returns are negative. This mitigates the impact of
HF composite
Treasury bonds
3-mo. Treasury rate
$400
FOFs
$300
$200
03
02
01
00
99
98
97
96
95
94
93
$0
another day.
92
negative returns over several years can survive to do so again
91
$100
89
performance. In contrast, traditional managers who deliver
90
industry has never produced a year of significant negative
Figure 2: Hedge fund returns versus other assets
2 I define composite hedge fund returns as an average of returns reported by
Evaluation Associates Inc. (EAI), Hedge Fund Research (HFR), CSFB, Hennessee
Group, Altvest, Van Hedge Fund Advisors International, and HedgeFund.Net
(TUNA). The comparison is to the S&P 500 Index, the Merrill Lynch Treasury Bond
Master Index, and the Merrill Lynch 3-month Treasury Index.
89
4.4% for bonds. Therefore, hedge fund performance is even
This conclusion is straightforward from standard Markowitz
more attractive on a relative basis, where the composite
portfolio optimization. In the most general case, there are no
hedge fund Sharpe ratio is 1.39 versus .41 for stocks and .70 for
restrictions whatsoever on security weights. Short selling is
bonds. This supports the often-heard contention that hedge
allowed and leverage may be employed - a situation that cor-
funds have stock-like returns with bond-like risk.
responds exactly to that of hedge funds. Traditional managers
possess the same objective function - maximizing returns sub-
The survivor bias issue
ject to risk, amended by the restrictions that all positions are
Critics sometimes challenge the reported performance of
positive (no short selling) and that asset weights sum to unity
hedge funds by asserting that available hedge fund data con-
(no leverage)4.
tain survivor bias and therefore overstate true returns. The
reason is that poorly performing hedge funds that go out of
For hedge funds, the absence of constraints means that they
business are dropped from databases, making reported
are able to construct more efficient portfolios and can achieve
returns higher and less volatile than would otherwise be the
higher returns for the same amount of risk. Their efficient
case. Estimates of this survivor bias range from 0.6% to near
frontier is superior to that of traditional managers under the
3.0% per annum3.
majority of circumstances by virtue of the fact that constraining investment choices forces a suboptimal solution (figure 3).
While survivor bias is a valid issue, researchers such as Liew
suggest an obvious solution - employing the FOF Index as a
12%
benchmark in lieu of the normal industry composites. FOF
managers must explicitly cope with survivor bias by actively
11%
Traditional -- no shorting, no leverage
replacing deceased or poorly performing funds with new ones.
Hedge funds -- shorting allowed
10%
survivor bias since their track record is based on the actual
performance of a real portfolio, including hedge funds that
may have experienced weak returns and closed. As already
noted, one can conclude that even under the most strenuous
Return
Therefore, the returns reported by any single FOF are free of
Hedge funds -- unconstrained
9%
8%
7%
standards in which FOF returns are employed as the industry
performance measure, hedge funds show the best perform-
6%
6%
7%
8%
9%
10%
11%
12%
Risk
ance on an absolute basis or relative to risk.
Figure 3: Efficient frontiers: traditional management versus hedge funds
The theoretical advantage of hedge funds
Hedge funds also possess an explicit theoretical advantage
that is well known to practitioners schooled in modern portfo-
Barriers to the paradigm shift
lio theory. This is simply that hedge funds practice uncon-
Institutional impediments
strained portfolio management. That is, they can hold both
Given the attractiveness of hedge fund performance and the
long and short positions, as well as leverage their portfolios.
advantages of the approach, why then is there any hesitation
This contrasts with traditional stock and bond managers who
to make significant allocations to hedge funds? The answer is
are limited to holding unleveraged long only positions.
that stock and bond managers have a vested interest in maintaining the status quo. Furthermore, significant institutional
barriers, including government regulations, have been erected
90
3 See studies by Brown, Goetzmann, and Ibbotsen; Brown, Goetzmann, and Park;
Fung and Hsieh; Liang; and more recently, Amin and Kat.
4 Traditional managers will often add even more constraints such as requiring
underweight or overweight positions to be within bands around the benchmark
weight.
to prevent new challenges to the old paradigm that stock and
Other impediments
bond exposure is sufficient to produce acceptable investment
It would seem that the government itself should be a catalyst
performance.
for challenging the status quo, since it would benefit citizen
investors. However, vested interests are powerful and the
The best example of this is pension plans, which are adminis-
lobby working to legitimize hedge fund investing is small.
tered by boards and staff who are rarely awarded on the basis
Indeed, there is an embedded barrier with government agen-
of performance. There is no incentive for creatively delivering
cies mandated to police against the risk inherent in investing
superior investment performance. Furthermore, many boards
in single hedge funds, not identifying and championing the
employ the services of established consultants, who are hired
benefits of investing in well-diversified hedge fund portfolios.
to advise on asset allocation and recommend stock and bond
While this is a good faith effort to protect the innocent, it
managers. Because most consultants’ expertise lies in select-
nonetheless is harmful from a portfolio diversification per-
ing traditional managers, they are loath to recommend alloca-
spective.
tions to hedge funds where they lack proficiency and could not
charge for manager searches. This system consequently per-
Countervailing forces
petuates stock and bond investing.
There is evidence that barriers are beginning to fall. Most
important is the fact that financial market intermediation is
Private investor barriers
underway, which is making access to hedge funds easier for
Individuals are much less limited by structural encumbrances
investors. This is most apparent in the rapid growth of the FOF
in making decisions and have tended to be more aggressive in
business where financial organizations such as banks provide
making hedge fund allocations. This is borne out by survey
due diligence and strategy allocation for a small fee. This
data, which show that individuals are the primary owners of
reduces the information gathering effort for investors by
hedge funds while institutional commitments remain minus-
leveraging off of large-scale research and due diligence plat-
cule relative to their asset base.
forms. Furthermore, ongoing industry consolidation is underway. This should further improve efficiency by combining such
Nonetheless, it is often very difficult for private investors to
platforms. Consolidation also deepens the availability of hedge
allocate to hedge funds. Not only are there government
fund products and increases the array of services available to
restrictions requiring investors to meet minimum income and
investors. As intermediation continues, the paradigm shift
net worth limits, but hedge funds are restricted in their mar-
should be further facilitated as new vested interests in the
keting practices, so information is difficult to obtain.
hedge fund business emerge.
Furthermore, most government sanctioned retirement and
savings programs do not allow investments in hedge funds.
Criticisms of hedge fund investing
Instead, the mutual fund industry is authorized to provide
In addition to proclaiming that reported hedge fund returns
investment products for individuals. Obviously, they choose to
are unreal due to survivor bias, the defenders of the status
present investors with a limited choice of funds in which to
quo have unleashed a bevy of other criticisms to hold back the
invest, a consequence of vested interest. As already demon-
tides of change. These include the allegation that hedge funds
strated, this has forced lower returns and more risk on
exhibit asymmetric returns, are opaque and illiquid, are not
investors than necessary by restricting portfolio diversifica-
tax efficient, and do not constitute a true asset class. These
tion to essentially two assets, stocks and bonds.
contentions need to be addressed least there be any lingering
doubts about the wisdom of hedge fund investing.
91
Category
Asset class/strategy
Average annual return
Std. dev.
Skew
Kurtosis
Max monthly gain
Min monthly gain
Sharpe ratio
Aggregates
Composite
FOFs
Equity market neutral
Merger arbitrage
Distressed
Long/short
Discretionary macro
CTAs/managed futures
S&P 500
Treasury bonds
3-mo. Treasuries
13.2%
11.2%
10.7%
8.4%
8.4%
9.4%
14.7%
16.3%
15.0%
13.3%
10.9%
7.8%
4.7%
6.1%
5.5%
3.8%
3.6%
2.6%
5.0%
6.5%
9.4%
2.6%
3.6%
15.1%
4.4%
1.8%
-.32
.10
-1.18*
-2.62*
-.23
-2.96*
-.48*
.24
-.13
.63*
-.45*
-.42*
-.13
3.97*
3.27*
1.97*
12.22*
.61
15.28*
5.59*
2.42*
2.04*
1.17*
.49
.57
-.23
7.7%
6.9%
3.4%
3.2%
2.7%
4.4%
7.6%
12.2%
8.0%
15.6%
11.4%
4.0%
8.9%
-7.6%
-5.9%
-3.2%
-5.7%
-1.6%
-8.8%
-8.7%
-9.1%
-9.4%
-7.0%
-14.5%
-4.0%
0.8%
1.39
1.19
1.60
1.03
1.43
0.95
1.55
1.24
3.94
2.42
0.41
0.70
--
Strategies
Other assets
An asterisk denotes statistical significance with 95% confidence. Based on an index of indexes using data from Evaluation Associates, HFR, CSFB, Hennessee, Van Hedge, Altvest,
TUNA, S&P, and Merrill Lynch. The underlying series are monthly beginning in January 1990 and concluding September 2003. Additional detail is available from the author.
Figure 4. Distribution statistics for various hedge fund indexes, 1990 to 2003
Asymmetric returns
particular, the lack of transparency means that some investors
One of the more recent criticisms of hedge funds is that
may have difficulty in adequately assessing the risks of a par-
returns are asymmetrically distributed. That is, they exhibit
ticular hedge fund and must rely on the manager to describe
negative skew and high kurtosis, implying that investors expe-
the underlying strategy employed. This contrasts with plain-
rience large downside surprises that are greater than would
vanilla stock and bond portfolio managers who are monitored
be the case if returns were symmetric. Indeed, researchers,
by a large number of independent research organizations that
such as Brooks and Kat, have identified negative skew empiri-
evaluate their performance. This has led to the suggestion
cally for numerous strategies, which Lo and Anson attribute to
that hedge funds should be required to reveal their positions
the use of options.
publicly.
The truth is that while various hedge fund strategies do in fact
The rejoinder is that hedge funds should not be required to
exhibit unusually large downside risk in isolation, well-diversi-
reveal their positions - their strategies and positions are con-
fied portfolios consisting of many managers employing differ-
fidential trade secrets and revelation could prove detrimental
ent hedge fund strategies do not. For example, an examination
to investors. Furthermore, hedge funds already report monthly
of the distribution of FOF returns does not show extreme
returns to investors. Style drift and risk can be easily ascer-
downside risk even though many of the constituent strategies
tained, if one is paying attention. Making more data available
do, such as convertible arbitrage, fixed income arbitrage,
frequently or allowing a more detailed look through to under-
merger arbitrage, and distressed debt (Figure 4). The reason
lying positions would not likely alter one’s conclusions on style
is simply that the asymmetries of different strategies offset
drift and risk. In this regard, the significant difference between
each other.
transparent mutual funds and hedge funds is that the onus of
due diligence falls much more heavily on the hedge fund
Lack of transparency and liquidity
investor. More work is required, both quantitative and qualita-
Another frequent criticism of hedge funds is that they lack
tive, to assure that one is receiving what is advertised by
transparency and are illiquid. While this is a long-running and
hedge funds.
somewhat tedious theme, it nonetheless has some merit. In
92 - The
In addition, the lack of transparency is often cited as a reason
example, many high net worth investors can use deferred com-
why there are incidents of hedge fund fraud. Although
pensation, private life insurance, and derivatives to effectively
extremely rare, more transparency would presumably be a
shelter hedge fund investment income. In this respect, while
deterrent. However, one must question whether this would be
hedge fund taxation may be a problem for small investors, it is
the case. Certainly there are situations when government
a deterrent to high net worth individuals only if they elect to
regulated companies misbehave. For example, transparency
make it so by ignoring tax management5.
did not prevent mutual funds from providing preferential
after-hours pricing in the recent market timing scandal.
Are hedge funds an asset class?
One remaining criticism of hedge funds is that they are not
As for liquidity, hedge funds are free to impose their own
really an asset class but simply a collection of strategies. While
requirements on exit conditions. Most restrict investor access
this assertion may appear valid on the surface, certainly one
to funds in order to facilitate the smooth unwinding of posi-
must admit that investing in traditional assets is also just a
tions that could be harmful to all investors if there were large
strategy as well. That is, owning stocks or bonds is a decision
redemptions. This is less an issue for mutual funds, which typ-
to hold naked long positions with no offsetting shorts.
ically deal in deep liquid markets. Even so, some mutual funds
do in fact close to new investment. Moreover, real estate and
This is clear conceptually if one reconsiders the general
private equity partnerships often require lock-ups that can
Markowitz case where portfolios consist of long, short, or zero
extend for as long as ten years. There is no public uproar when
positions in various securities. In this sense, traditional asset
this occurs yet this is little different from hedge funds.
management is a special case in which short positions are
prohibited. Consequently, hedge fund strategies are revealed
Tax efficiency
as more complex ‘spread’ exposures. Returns accrue not from
A third criticism of hedge fund investing is that it is not tax
the raw return of the underlying securities, but as a result of
efficient [Schumadine (2003)]. The reason is that much of the
whether spreads expand or contract. This implies straightfor-
income from hedge funds arises from short-term trading
wardly that hedge funds are more complex than traditional
activity, as well as from nonqualified dividends and interest
assets.
payments. These returns are taxable at ordinary rates for individuals, which can be as high as 50% in some jurisdictions.
Hedge fund income is, therefore, much less tax beneficial than
100%
say equities, which typically qualify for long term capital gains
90%
rates. Of course, this issue is largely irrelevant for institutions
80%
and endowments, which are generally not subject to taxation.
70%
However, for individual investors, both in the U.S. and Europe,
60%
impediment that reduces after-tax returns.
Bonds
Allocation
the aggressive taxation of hedge fund income is an obvious
Stocks
Cash
Hedge funds
50%
40%
30%
20%
exposure as nontaxable entities but that exposure should be
implemented via nontaxable or tax-deferred structures. For
12
%
11%
10
%
9%
8%
7%
6%
5%
4%
0%
regard, investors should hold essentially the same hedge fund
3%
10%
high net worth private investors, not an allocation issue. In this
2%
That said, hedge fund taxation is an asset location problem for
Risk
Figure 5: Optimum asset allocation 1990 to 2003
5 Paulson makes this case strongly, advocating tax efficiency via swaps,
life insurance, grantor trusts, grantor retained annuity trusts, charitable lead
annuities, and other structures.
93
Alpha generation - genius or camouflaged beta exposure?
asset allocations shown in Figure 5. The results, which cover
Are hedge fund managers true geniuses in producing excep-
the 1990 to 2003 period, indicate that medium risk investors
tional returns, or is their performance simply the result of the
should have held near 100% in hedge funds over the period,
unique spread exposure they carry? While some proponents
while more conservative and aggressive investors should have
argue the former, the truth appears to be that the majority of
held smaller hedge fund allocations in order to reach their
hedge fund managers do not in fact exhibit exceptional skill.
more extreme risk targets. That said, the minimum hedge fund
Rather it is their unique exposures that produce attractive
allocation held by any investor should have been 25%. Clearly,
performance profiles. In this sense, hedge fund strategies only
the opportunity cost of holding no hedge fund allocation was
appear to produce alpha versus traditional assets and it is
very high, a loss of more than 3% annually for medium risk
their underlying beta exposure that delivers performance.
investors.
Thus, apparent alpha is really camouflaged beta.
Of course, the real acid test is future performance. Here one
The evidence comes from Fung and Hsieh, and Lamm, who
may have a valid argument for smaller hedge fund allocations
examine the positions typically carried by equity hedge man-
if relative risk-adjusted hedge fund returns decline versus past
agers. They demonstrate that equity hedge managers have
relationships vis-à-vis stocks, bonds, and cash6. However, a
historically carried long exposures primarily in small cap
substantial change from past behavior is required to produce
stocks offset by short positions in large capitalization stocks.
much lower hedge fund allocations. For example, future hedge
Because small capitalization stocks normally outperform large
fund returns must decline by more than 2.5% annually versus
cap stocks, such positions should therefore produce positive
stocks and bonds before the optimum allocation to hedge
returns with no special skills whatsoever.
funds begins to fall below 20% for any risk level. To presume
such would appear to require heroic assumptions and a great
Similarly, it can be argued that the unique exposures carried
leap of faith. Therefore, the best forward-looking asset alloca-
by hedge funds engaged in strategies, such as convertible
tion would still appear to favor allocations of a fifth or more of
arbitrage, fixed income arbitrage, and distressed debt are really
the total investment portfolio.
camouflaged beta. The only way to access these exposures is
via hedge funds. There are no mutual funds that offer such
Conclusions
positions, nor can investors do their own research and buy
Revolutions are typically accompanied by dramatic structural
spread securities in publicly traded markets.
change as old ideas are cast aside and replaced with a new
paradigm. Clearly, because hedge funds are not yet universal-
How much should investors allocate to hedge funds?
ly accepted, the revolution is incomplete. Nonetheless, a fun-
Portfolio construction is a forward-looking process involving
damental transformation appears to have begun despite the
expected future returns and covariances. For this reason,
fact that many hedge fund skeptics remain.
examining the best retrospective allocation serves little useful
purpose except to demonstrate what might have been
The guardians of the status quo argue that hedge fund returns
attained with perfect foresight. Nonetheless, this exercise is
are asymmetric, data suffer from survivor bias, hedge funds
useful to establish a reference point.
lack liquidity and transparency, and that after-tax returns are
not attractive. While there is a modicum of truth to these
Taking FOF returns as the measure of hedge fund perform-
assertions, it must be remembered that opponents often have
ance along with the appropriate data for stocks, bonds, and
a vested financial interest in the maintaining the stock and
cash as described in Figure 4, leads to the optimal Markowitz
bond creed. Furthermore, the critics lack sufficient expertise
6 Allocations may also be affected if covariances change dramatically from the past.
94 - The
to evaluate hedge funds and, like the flat earth proponents of
References
old, fear the unknown, which they may not understand.
•
The evidence presented here indicates that hedge funds have
•
performed well in the past, even after one makes adjustments
•
by using conservative FOF indexes as return benchmarks to
adjust for survivor bias. While it is possible that the future is
•
different and hedge funds do not outperform, there are many
reasons to suspect they will. Indeed, the fact that so many
•
skeptics remain implies that it will take a while for structural
barriers to fall and the influence of vested interests to abate.
•
This means that the process of arbitraging away the superior
•
risk-adjusted performance of hedge funds has a way to go.
•
•
•
•
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•
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•
•
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•
•
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95
Titel artikel
Hoofdtiteltje
Bodycopy bodycopy bodycopy bodycopy bodycopy bodycopy
bodycopy bodycopy bodycopy bodycopy bodycopy bodycopy
Tussentiteltje
96 - The
Opportunities
Hedge funds
in Asia
Peter Douglas1
AIMA Council Member for Singapore,
Principal, GFIA pte ltd,
and Research-Director, Dewey Douglas Ltd.
Abstract
Asia’s core attraction to global asset allocators is that there
This article provides an overview of the industry in Asia, pri-
are some world class managers who typically still have capac-
marily for the benefit of potential allocators. While I have tried
ity. Cyclically, renewed investment interest in Asia and result-
to include hard data, reporting schedules and a very rapidly
ing liquidity flows are rapidly increasing demand and to a cer-
developing industry mean that the numbers will inevitably be
tain extent, supply. The industry achieved critical mass in
out of date by the time you read this; qualitative comment is
2003 in terms of size, number of managers, and in particular
of far more commercial value. I have therefore tried to provide
the quality of start-ups.
as much qualitative color to the picture as possible, and have
emphasized the commercially useful over the statistically per-
Allocating to a hedge fund manager is the result of a search
fect wherever possible.
for talent allied with capacity, and this is no different in Asia.
But global allocators looking to managers in Asia will find
Information is attributed wherever appropriate. Otherwise,
some different characteristics, some driven by the youth of
opinions and observations are my own and not necessarily
the industry, some by the nature of the underlying capital
those of GFIA pte ltd.
markets, and some cultural.
1
I would like to thank Paul Storey, editor of AsiaHedge, and Joanne Murphy,
head of hedge funds for Asia for Bank of Bermuda, for their comments,
suggestions, and contribution to the scope of this article, and EurekaHedge for
access to their database. Low Jeng-Tek, INSEAD research assistant, and Enio
Shinohara, INSEAD MBA candidate, contributed significantly to earlier revisions of
this article. Mr Low is now a director of Everest Capital Analytics Inc and
Mr. Shinohara a principal of GFIA pte ltd.
97
Hedge funds in Asia
Global asset allocators are beginning to review the universe of
an initial screen by a fiduciary investor would approach 150.
hedge fund managers in Asia more seriously, and are begin-
Again, this is a significant increase – perhaps 50% - from 12
ning to allocate capital to take advantage of quality managers,
months ago.
even as some of the more directional capital leaves the region.
The fastest growing source of new members for the Alterna-
Applying a rough and ready 80:20 rule to these numbers, we
tive Investment Management Association (AIMA, the industry
could assume that about 30 would at any one time be appro-
body for the hedge fund industry) is Asia, with currently more
priate for serious consideration. While this is a small absolute
than 21% of global membership in the region. In Singapore
number, it is probably about the same ratio of total funds to
alone there are 22 members, up from only 2 in 2000.
quality candidates as the hedge fund universe in either the
U.S.A. or Europe, and it is certainly a large enough universe to
A survey at the beginning of 2003 suggested that global allo-
keep an analyst busy full-time. However the geographic dis-
cators currently had of the order of 2.5% of their assets in
persion (Figure 2) of the managers’ locations means that,
Asian strategies, their intention in aggregate is to increase this
although first-level screening can arguably be done anywhere
over a six-month period by 44%2. In the first half of 2003,
in the world, qualitative due diligence, including building trust
AsiaHedge, the industry journal for the Asian hedge fund
and confidence with a manager, can be tough for allocators
industry, reports that aggregate assets only increased by 6%,
without a physical presence in the region.
but asset growth accelerated dramatically in the second half
and our guess is that, when final data is available, we will see
300
that the industry did in fact grow by around 50% in 2003, with
250
newer funds that, qualitatively, deserve serious attention
(sometimes because they are spawned by an already stable
organization), and that the universe of funds that might pass
2 Source: Deutsche Bank ‘Alternative Investment Survey’, 2003
98
U.
S.
A
35
32
16
3
Ko
re
a
Ja
pa
n
So
ut
h
Ch
in
a
Au
st
ra
lia
0
Asian hedge funds, suggests that there are some smaller and
U.
K.
59
6
3
2
Ot
he
rs
gement.
20
66
Ta
iw
an
40
61
U.
S.
A
60
groups have less than U.S.$ 50 million of assets under mana-
Research conducted by GFIA, an independent researcher of
Si
ng
ap
or
e
89
80
U.
K.
differently, AsiaHedge estimates that 35% of management
100
Th
ai
la
nd
the industry here (Figure 1). Looking at the numbers slightly
25
Figure 1: Average AUM by manager location
Source: Asiahedge April 2003, exept S Korea estimate, GFIA April 2003
more under management and at least a 12-month history, we
in the last six months, reflecting the shift to critical mass of
30
0
If we slice this to include only funds with U.S.$ 50 million or
arrive at a universe of 126 funds – a number which has doubled
73
50
Ko
re
a
Japan and Australia, an increase of almost 30% in 12 months!
83
M
al
ay
sia
Si
ng
ap
or
e
hedge fund broker, there are 372 Asian hedge funds, including
100
Ja
pa
n
According to EurekaHedge, a Singapore-based specialist
170
140
150
So
ut
h
becoming an inescapable part of the hedge fund world.
200
Ch
in
a
about U.S.$ 40 billion. There is no doubt that Asia is rapidly
Au
st
ra
lia
preliminary estimates suggesting the universe now totals
Note: (i) Australia is
heavily skewed by two
managers - median size
is probably comparable
with Singapore (ii) China
includes Hong Kong (iii)
total excludes offshoredomiciled managers.
270
Figure 2: Location of decision maker
Source: Eurekahedge Jan 2004
Note: (i) Many Japanese managers are domiciled offshore and the total for Japan
therefore understates the number of Japan-based strategies (ii) China includes
Hong Kong (iii) total excludes offshore domiciled managers.
Hedge funds in Asia
Rel val
22
Intuitively, managers based in the region should have better
Multi-stat
46
access to information and therefore better performance, but
there is no hard research to suggest this is the case. There are
some powerful Asian strategies run from London, New York,
and other locations ex-Asia.
Macro
23
Fixed income arb
7
Event driven
6 CTA
Long/short
equity
198
15
Distressed debt
7
CB arb
8
The manager breakdown by location broadly is as follows:
Japan has some large managers, aided by the (relative) liquidity of the stock market and availability of stock borrowing.
Given that the restructuring of Japan is being emphasized at
the micro level (even if by default due to the lack of restructuring at the macro level), unsurprisingly equity l/s is the dominant strategy. Most Japanese managers have a dual office
Figure 3: Strategies of Asian managers
structure, with an onshore and an offshore base, driven by tax
considerations – many in fact have no, or a token presence,
When I first started researching Asian hedge funds in 1998, a
onshore, with London, Singapore, and Sydney being popular
common complaint was that, with no more than one or two
locations. Interestingly, the indigenous managers are now
exceptions, they were mostly go-go mutual funds with a per-
gaining some visibility, with one of the largest locally-run
formance fee. While I do not think that was ever a totally fair
funds being in excess of U.S.$ 1 billion of assets. An increasing
criticism, it is true that the universe was initially dominated by
number of Japanese financial institutions have set up internal
fundamentally driven, long-biased, directional long-short equi-
hedge fund management operations. GFIA expects to see
ty managers. Some of the early Asian hedge funds were
more local Japanese managers gain visibility over the next 12
unashamedly chasing the highest returns possible from equi-
months as absolute-return boutiques bolt on hedged strategies.
ty implementation of macro-type thematic bets (and, in their
defense, some have grown exceptionally skilled at producing
There is some fund of funds presence in Tokyo.
high beta with a strong stop loss discipline).
Hong Kong has a substantial industry, aided by the relative
There is still a predominance of equity long-short managers,
depth of the conventional money management industry there.
and the majority of those are still broadly Jones-model man-
The majority of Hong Kong funds are therefore equity long-
agers who may do best in sideways or rising markets. But with-
short, with a smaller number of successful fixed income and
in the catch-all category of equity long-short, there are single-
relative value players. There are a couple of global funds-of-
country, sector-specific, model-driven, trading, and other
funds with local presence, and at least 4 indigenous fund of
niche strategies, as well as of course huge divergence of man-
fund groups. As the world slowly comes to terms with the awe-
ager style. Recently – and understandably in the liquidity-driv-
some reality (no longer do we talk of ‘potential’) of the Chinese
en bull market we saw in the second half of 2003 – many equi-
economy, demand for strategies that understand China is
ty managers have become significantly directional and have
increasing, and that expertise is, typically, concentrated in
increased market exposure. There has also been growth in
Hong Kong. At least two major mainland Chinese corporates
CTA-type, fixed income, multi-strategy, and relative value man-
are running internal hedge funds with differing degrees of vis-
agers (Figure 3).
ibility. We expect Hong Kong to own the China theme niche
99
Hedge funds in Asia
definitively (though there are also China theme hedge funds
South Korea is beginning to come of age. Radically easier
run from New York, Singapore, Shanghai, and elsewhere). For
stock borrowing in 2003, a rapidly restructuring economy, and
other strategies, the relative rate of growth appears to be
a deep but inefficient stock market, are stimulating Korea-
slowing slightly.
specific hedge funds. This is likely to continue and I expect the
development of Korean funds to track that of Japanese funds,
Singapore has a newer and relatively small industry (although
with initially a few directional long/short equity funds, eventu-
numbers of managers are on a par with Hong Kong), but is
ally deepening into a good universe of strategies broadly mir-
demonstrating a couple of niches in Japan strategies, and rel-
roring the pan-Asian strategy mix. Some of the larger Korean
ative value and other non-equity strategies (driven by the
institutions have already initiated strategic allocations to
number of banks that have proprietary trading centered in
hedged assets, and distributors are reporting growing demand
Singapore, as a key source of management talent). A small
from the HNW and mass affluent markets. This is likely to be
number of global funds-of-funds have some representation in
an increasingly important market in the future.
the Republic. Singapore’s core strength is that for senior professionals it offers a more comfortable quality of life than any
The Asian capital markets still limit opportunities for event-
other investment centre in the time zone outside Australia;
driven managers, stat arbitrage traders, and pure market neu-
furthermore the regulatory environment is extremely friendly
tral players, though there are examples of all these types with-
to boutique operations. During 2003, there were roughly as
in the industry. However, in the search for talent and capacity,
many live launches in Singapore as Hong Kong, so the rate of
there is enough here to keep the global allocator interested. In
growth of the relatively smaller industry in Singapore is high-
particular, the last 12-24 months have seen an increase in the
er. Subjectively, a large proportion of Singapore’s new launch-
number of managers with low or minimal correlation to equi-
es were highly credible, suggesting that asset growth could
ty markets, either by careful hedging or by remaining with
follow fund formation quite rapidly as the Republic is per-
non-equity assets.
ceived to be the base of choice of the more institutional quality managers. There are no funds-of-funds run from Singapore
Appetite for capital
though a couple of local institutions run their allocations as
In 2003, 90 new hedge funds started in Asia (compared with
internal funds-of-funds.
66 in 2002), raising an aggregate U.S.$ 5 billion3. That is an
increase of over 40% in the number of funds, with an average
Australia has a vibrant hedge fund industry, stimulated sig-
of more than U.S.$ 50 million per launch, double 1993’s aver-
nificantly by the growing tendency of local institutions to
age launch size (though the median would be lower than this).
make allocations to alternatives – more than 30 retirement
The picture for 2004, as I write this piece, is likely to be com-
funds now have explicit allocations to hedged products, and
parable, as star financial professionals see the opportunity,
both the number and volume of assets committed is growing
and allocators are increasingly prepared to make the journey
rapidly. Many managers are, however, small, but the top half
to Asia. Subjectively it feels as if the typical quality of start-up
dozen are receiving meaningful allocations from global man-
is improving, partly as the footprints of those that have gone
agers, with some soft closed, and there are at least 2 billion-
before help newcomers avoid mistakes, and partly as financial
dollar managers in Australia. Strategies represented are an
institutions are now shedding real muscle into the market-
eclectic mix, including domestic, regional, and Japanese
place, with star professionals looking for second careers.
strategies. Australia is aided by its superb quality of life,
Furthermore, as more and more seasoned allocators trawl
attracting mid-career professionals, and by the accessibility to
Asia for talent, managers are exposed to global competition
global markets and business afforded by technology.
and a global standard of organizational competence.
3 Source: Bank of Bermuda estimate
100 - The
Hedge funds in Asia
120
First, the industry is young. Fewer than 150 funds have been
112
# funds
100
80
running for more than three years (and only 64 for more than
five years) and therefore the supply of graduates possessing a
70
60
43
track record and reputation from existing firms is limited. The
51
40
40
0
industry is beginning to outgrow this constraint (the number
of three-year-old funds has increased 50% in the last year)
20
8
<10
10-50
50-100
100-200
200-500
asset size U.S.$m
500-1bn
4
but for now, constraint it is. Asia is not a conventional lifestyle
>1bn
destination for professionals leaving careers in the U.S. and
Figure 4: AUM by fund
Europe to resettle, so apart from a few hedonists in Singapore
and Sydney, few experienced professionals choose to relocate
to Asia from elsewhere. So, talent is typically new to the hedge
Figure 4 demonstrates that the typical Asian hedge fund is still
fund industry, usually from long-only asset management
a small business – but not as small as a year ago. Only 48% of
houses, or proprietary trading, with the learning curves wide-
Asian hedge funds have less than U.S.$ 50 million under man-
ly associated with those career paths, and resulting hesitation
agement, compared with more than 60% a year ago. In mid-
on the part of allocators. One of the implications for an allo-
2003, Asiahedge calculated that the 5 largest funds in the
cator is that the organization needs to show a good learning
region controlled 26% of the assets, though that concentra-
feedback loop – often an excellent manager will produce the
tion appeared to weaken a little over the last year as the
best returns after 12-18 months of running a hedge fund, when
industry deepened.
he has learnt the hardest lessons, and allocators need to be
sensitive to where in the learning cycle the manager is, in a
Doing some quick and dirty math, many Asian managers
way that they would not for an experienced hedge fund
probably generate less than U.S.$ 1 million a year in revenues,
manager.
for a business that needs at minimum two or three highly
experienced financial professionals, and usually must service
Secondly, many allocators are unfamiliar with the capital
an international client base. Almost a third of all Asian hedge
markets in Asia, and therefore are less comfortable with
funds have been in business for over a year but still have less
strategies in this playground. The nature of the markets here
than U.S.$ 50 million under management. That is a great deal
has some implications for the industry, too.
of personal commitment for the managers running those
strategies.
Regulatory environment
This is unsurprisingly a short section. Most Asian hedge funds,
Even in the U.S. and Europe, many start-ups struggle to
while they may have an onshore advisor conforming to local
achieve critical mass. But in Asia even managers who bring
regulations, offer offshore and largely unregulated products.
significant credibility to a new operation have found it difficult
Furthermore, to date, most Asian allocators and investors
to achieve scale quickly. This is beginning to change, but a
have preferred to invest in such structures. A long discussion
really credible and well-resourced new operation cannot hope
of regulations would be fruitless, with the exception of some
to raise assets as rapidly as their counterparts in Mayfair or
comments about the appearance of regulated retail-oriented
mid-town.
products, which are feasible, though arguably not that important yet, in several jurisdictions.
There are several reasons for this.
The industry in Asia typically offers Cayman structures, U.S.
101
Hedge funds in Asia
LLPs, and separate accounts, and global allocators face few
All the Asian markets have different characteristics, in terms
regulatory hurdles. In most cases, allocators need only confirm
of the sectors represented, trading patterns, liquidity, and,
as part of their organizational due diligence process that the
importantly, availability, cost, and convenience of stock bor-
onshore management company is appropriately regulated and
row. This of course creates arbitrage and diversification
licensed – their counterparty risk will be with a type of struc-
opportunities, but the dictum that ‘in a bear market the only
ture with which they are very familiar.
thing that goes up is correlation’ is as true of public equity in
the region as any other asset class globally.
Some managers in some jurisdictions (Australia, Japan) offer
domestic funds for local investors who find offshore struc-
Compared with developed markets, there is less corporate
tures difficult for tax or other reasons.
activity in public markets (and therefore few event-driven
strategies), but a resilient and sustainable supply of distressed
Australia, Hong Kong, Japan, and Singapore all allow retail
paper; typically thin fixed income markets but from high qual-
offerings of hedged product. The requirements in each juris-
ity issuers, a fairly high quality supply of CB paper; and some
diction differ, and as always the commercial realities of distri-
large but very inefficient derivatives markets, etc. The oppor-
bution and demand will dictate whether a manager wishes to
tunity set is colored differently in Asia.
offer products to local retail markets and consequently
whether the cost of a domestic structure is warranted. To date
Liquidity is a rapidly moving target, meaning that accurate
only Japan has seen really significant demand, with Australia
hedging is often either difficult or expensive, or both – market
making some headway. In Hong Kong and Singapore retail
neutral is at best a target, not a measurable result, in Asia. Gap
demand has been slow to appear.
risk can be high, and the clever arbitrage strategies have a
habit of exhibiting nasty tails from time to time. Allocators
Characteristics specific to Asian strategies
must demand higher returns to compensate for these risks.
Asia is not a single market. Depending on their strategy, man-
102 - The
agers may focus on one single market, a small handful of the
To ensure a supply of consistently profitable trades, a large
friendliest, or 14 different markets (the number of markets
proportion of managers are multi-strategy, in fact, if not in
included in the widely used MSCI indices). Geographically,
name. This can be difficult for allocators who prefer a clear
remember that after your 13 hour flight from London (or, may
definition, or use quantitative optimization models that work
Allah help you, your epic multi-hop trek from Chicago, losing a
best with clean strategies. Moreover, allocators need to differ-
day of your life in the process) to Singapore, the geographic
entiate between style drift, and perfectly legitimate changes
centre of the region, you still have a 7 hour flight to Tokyo or
in capital allocation within a fund. This is partly because Asia
Seoul, a 4 hour flight to Hong Kong, a 5 hour flight to
is (always?) in transition and that is also true of its capital mar-
Shanghai, and a 7 hour flight to Sydney. Although almost all
kets. What might be a red light elsewhere in the world may be
financial professionals speak English, you will have to negoti-
pragmatic in Asia. One of the better Japan long/short equity
ate with taxi drivers that speak in a host of languages you do
managers, for example, says ‘I’d much prefer to do my
not understand, and a different currency in each country. And
research, find my Microsoft, and run it for several market
best not to forget whether you should be thinking of Christian,
cycles, and when it’s right to do that, I will – but over the last
Buddhist, Hindu, Muslim, or a host of other country-specific
few years market conditions have dictated that I trade’. And he
holidays (Respect for the Aged Day… International Women’s
does, sometimes moving net long to net short and back with-
Working Day…. Picnic Day….etc.!) when you are planning your
in a month – and by doing so has annualized over 22% return
itinerary.
since inception four years ago. Will I still back him when he
Hedge funds in Asia
finds his Microsoft, despite the dramatic strategy shift this will
time zones, long flights, and infrequent face to face contact)
entail? In principle, yes, as his strategy will very much follow
slows the rate of investment.
his deep understanding of the market structure, which is what
he is paid for.
The silver lining of Asia, until mid-2003 was that most Asian
managers had capacity. The capacity picture of Asia is howev-
Asian shops are, broadly, split into those run by western, or
er beginning to resemble that of the rest of the world, with
western-minded, managers, and indigenous, local managers.
popular managers soft-closing within 12-24 months. This is
Cultural differences can be overstated – at the end of the day,
exacerbated by the smaller volume of underlying capital mar-
capitalism is capitalism. However I would make a couple of
kets in Asia that constrains managers to smaller asset sizes.
comments (necessarily general – remember, Asia is not
Only about 3% of Asian funds have more than U.S.$ 500 mil-
homogenous). First, in most Asian countries, going independ-
lion of assets, and of those, to my knowledge, fewer than half
ent is considered a one-way street, with no way back into con-
are accepting capital and those are predominantly currency or
ventional employment. That is an extra disincentive (and, con-
CTA strategies.
versely, an extra badge of courage) for Asian managers to set
up. A number of really good managers in the region do not
A typical equity long/short manager in Japan would have
have the cultured polish of the Manhattan or Mayfair crowd,
capacity of perhaps U.S.$ 500 million, and in Asia ex-Japan,
and although a good allocator will see through the polish or
maybe U.S.$ 250 million. Liquidity has been increasing but
lack of it, it is a hindrance to rapid growth. Finally, many Asian
underlying capacity rises more slowly due to constraints on
business people have a culture of control, both of people and
short availability, the need to apply leverage, and an increased
of cash. Many indigenous firms are characterized by a hierar-
number of market participants. There are more than 70 Japan
chy that feels odd to an allocator used to looking at a more
long-short funds that have assets of less than U.S.$ 500 mil-
collegiate organization – and many are frankly under-
lion (of which, from experience, at least 30 would warrant
resourced in terms of numbers and caliber of support (and
some interest from a fiduciary investor); in Asia ex-Japan, 42
sometimes investment) staff, in the interests of cash conser-
funds have less than U.S.$ 200 million, and the same empiri-
vation. I spend a great deal more of my time than my peers
cal screen yields another 30 or so of interest to the profes-
elsewhere in the world looking at organizational risk – it is a
sional investor4.
key success factor in allocating to Asian hedge funds.
Managers do close, and approximately 30 funds have left the
An advantage, however, is the very real manager diversifica-
universe during 2003 (less than 10% of the universe, compa-
tion between indigenous and foreign managers. One of the
rable or even slightly lower than other regions). Although the
very good Japan long/short managers I track, owned and
rationale for closing is not always publicized, the list mostly
managed by local professionals, typically has negative or very
comprises funds that were consistently too small to be prof-
low correlations with its foreigner-operated peer group that
itable. I can only spot two accidents in there, neither of them
cover a similar universe of stocks in superficially very similar
widely held.
strategies. The demonstrable quantitative difference is
explained definitively by very cultural, qualitative differences
Adding all this up, GFIA estimates that currently the good
in the mindset of the professionals in the business.
managers in the region still have an aggregate capacity somewhere in excess of U.S.$ 10 billion – and this has not, despite
But allocators do need to spend more time on their Asian man-
capital inflows, changed much in the last 12 months. Although
agers, and this, with the double whammy of distance (awkward
better known names are getting difficult to access, there is a
4 All these figures are sourced from Eurekahedge’s database; the empirical figures
are from GFIA
103
Hedge funds in Asia
healthy pipeline of good quality start-ups and allocators pre-
Some funds-of-funds groups have packaged their products
pared to do the work will continue to find the capacity they
successfully to appeal to a wider spectrum of distribution,
need. In terms of sourcing good capacity, allocators focusing
such as IFAs and stockbrokers.
exclusively on the U.S. and Europe are missing a large part of
the potential universe.
While demand from private banking clients across the region
appears broadly homogenous, at the institutional and fiduci-
So allocators that are prepared to do the work, have a window
ary investor level, the region exhibits diverse characteristics.
of opportunity to find high quality talent, in strategies that
may well have little correlation to their existing holdings – and
Japan accounts for approximately 10% of global demand for
actually find that the manager is happy to take their money.
funds of hedge funds5, and much of this has been from longterm investing institutions, such as life assurance companies
A final implication of the lack of capital in Asia is that, gener-
(this group alone is estimated to have invested U.S.$ 9 billion6 )
ally, information flows are good, as managers realize they
and banks (U.S.$ 4.5 billion7 - these are old figures and by now
must be flexible to woo investors. However I am beginning to
are almost certainly 20% or more higher). Many of Japan’s
see a little more reticence at the margin – again, Asian man-
institutional investors have been exposed to the industry since
agers are importing the standards of managers in more devel-
the early to mid-1990s and are now among the world’s more
oped jurisdictions.
sophisticated allocators.
A specialist Asian fund of funds I worked with obtained ongo-
Hong Kong has a small number of sophisticated family offices
ing full position disclosure from all but one of the equity man-
who are very familiar with hedged assets. Generally, however,
agers in its portfolio. I switched capital from a U.S.-based fund
Asian family offices are relatively unsophisticated in allocating
to a very similar strategy based in Hong Kong (with similar
to alternatives, and have smaller amounts of liquid assets than
quant characteristics but about half the capital) purely
their U.S. or European counterparts, as typically they are
because the information flow from the mid-town manager was
managing excess liquidity of a family business and not the pro-
always late, thin, and inflexible, while the Asian manager was
ceeds of the sale of a business.
happy to provide virtually any information I needed, immediately. This is an extreme example but not atypical.
At least two major fiduciary investing institutions have made
allocations to hedge funds, advised by traditional asset con-
Asian appetite for hedged product
sultants as part of a formalized portfolio construction process;
Across the region, the major private banks have been active
In this respect, Hong Kong resembles other institutional mar-
for many years selling hedged product – largely funds-of-funds
kets in Europe and elsewhere. Although the total assets are
– to wealthy families and individuals. Over the last two to three
not large, there is a depth of understanding of hedge fund allo-
years this product push has reached down to the priority
cation skills in the territory.
banking level, so the middle class professional with a few hun-
104 - The
dred thousand dollars in the bank has typically already been
Two major public sector institutions in Singapore are taking
exposed to hedged, and in particular, fund of fund product. As
the asset class seriously, and if they are seen to be successful,
always with the private banking industry, hard numbers are
the generally homogenous institutional market in the Republic
not available but sales are reported to be substantial. This may
will follow suit. Reported forthcoming changes in the legisla-
partially explain why retail response to funds-of-funds has
tion controlling trustee investments may accelerate alloca-
been weak – much of the demand has been satisfied already.
tions.
5 Source: Barra Consulting 2001. The author believes that although Barra’s absolute
numbers will have changed significantly in the intervening 3 years, the ratio cited
is probably relatively stable.
6 Source: AIP Tokyo estimate, September 2002
7 Ibid
Australian superannuation funds have been quietly making
After a treacherous 2002 in which returns were typically mod-
allocations for 2-3 years now, and it is estimated that perhaps
erate and dispersed, with many managers shrinking their bal-
a couple of dozen have now some exposure, either through a
ance sheets, 2003 was a much more comfortable year. The
portfolio of single manager funds or funds of hedge funds.
ABN Amro EurekaHedge index returned a creditable 4.4% in
There appears to be at best moderate interest from family
2002, but then a much more headline-worthy 27.3% in 2003,
offices.
and has annualized at 12% since the index’s inception in
January 20008. Asian equity valuations remain undemanding,
Other Asian markets, such as Taiwan and South Korea, are
though no longer generally cheap, and credit is strong.
making inroads. South Korea in particular looks interesting as
Generally market liquidity is increasing both cyclically and
at least two major institutional investors have made alloca-
structurally.
tions – in a largely homogenous environment, visible trendsetters can prove a powerful catalyst.
A number of managers are reshaping their strategies in reaction to recent market conditions. Some are widening their uni-
Current environment
verse (Japan managers beginning to add Korea, for example).
One of the themes evident in the Asian hedge fund industry is
Some are emphasizing trading, as I have discussed. Many new
how the alpha from beta seekers are being replaced by more
start-ups are focusing on non-equity sectors of the capital
mainstream allocators. The international money in Asian
markets.
hedge funds has often been attracted by the Asian growth
story. Some managers (in particular some of those located
Future developments
outside the region) have built good businesses riding the
I can see no reason why the number of managers in the region
waves, but hedge funds are not the best way to ride a liquidi-
should not continue to grow at a net 25% per year or more. As
ty driven bull market. During 2002, and continuing into 2003,
the capital markets industries reshape, increasing numbers of
there was a gradual erosion of holdings by Asiaphile investors,
competent managers will seek to build independent businesses.
replaced with allocations from large global allocators who
were less impressed with the Asia story than with the simple
Aggregate capacity may become more of a limiter within the
fact of managers doing the right job, with available capacity.
next 12-24 months, and we are beginning to see the cream of
While the number of these allocators is currently small
Asian managers move to soft closing, with several already
(around 15-20 houses appear to have credible research aware-
hard closed. Allocators will increasingly need on-the-ground
ness of the region), both the number of managers on the radar
expertise to ensure early access to attractive funds.
screen, and the number of allocators interested, appear to be
Increasingly global allocators are including Asia in their uni-
growing. By the final quarter of 2003, many of the better
verse – not to do so would mean excluding an increasingly
known hedge fund allocators were either investing, or evi-
meaningful slice of the global opportunity set.
dently doing serious desk work prior to investing, in the Asian
hedge fund universe. Almost all of 2003’s growth in assets
In summary, it is the inefficiencies in Asian capital and infor-
occurred in the final four months of the year.
mation markets which are creating good returns, and in the
near term these returns are being amplified by good market
One interesting phenomenon of the last few months, as Asian
liquidity. Investors should expect both returns and volatilities
markets have raced ahead, is that dedicated hedge fund allo-
to be higher, strategy by strategy, in Asia than in a developed
cators have been including absolute return long-only equity
market. However the universe of Asian managers is less and
managers in their searches.
less directional, and increasingly able to capture returns from
a wider range of opportunity sets.
8 These are GFIA calculations on preliminary EurekaHedge data as final numbers
were not available at time of printing
105
Titel artikel
Hoofdtiteltje
Tussentiteltje
106 - The
Opportunities
Key findings of
the Edhec ‘European
alternative
multi-management
practices’ survey1
Noel Amenc
Professor of Finance, Edhec Business School
and Research Director, Misys Asset Management Systems
Jean-René Giraud
CEO, Edhec-Risk Advisory
Abstract
This article provides the key findings of Edhec European
Alternative Multi-management Practices Survey. It provides a
detailed summary of the results of the survey of the 61 multimanagers carried out, as well as details of the research performed both by Edhec and numerous other professional and
academic institutions in the area of alternative multimanagement.
1
This article is a summary of the key findings of Edhec ‘European Alternative Multimanagement Practices’ survey released in December 2003. This survey is a
combination of a permanent ‘industry and academic intelligence’ carried within
Edhec Risk and Asset Management Centre and an in-depth analysis of the
responses to questionnaires sent to a large number of industry representatives.
The work has been carried by a team led by Noël Amenc with the support of Anne
Delaunay, Jean-René Giraud, Félix Goltz, Lionel Martellini and Mathieu Vaissié. The
110 pages report is freely available in PDF format on www.edhec-risk.com.
107
Hedge funds have recently been at the centre of numerous
debates, either as alternatives to traditional long-only invest-
35%
Other European countries
23%
ments, or because of the very specific risk they carry due to
their trading strategies and a fairly unregulated environment.
France
If hedge funds have built the success we know of, based on the
United Kingdom
very concept of superior and absolute performance, the
7%
18%
26%
21%
33%
Switzerland
28%
appetite institutional investors now have for such investment
0%
vehicles might grow from a very different angle and is not
without impact upon the industry.
Funds of hedge funds, and more generally alternative multimanagement, can be considered as the natural gateway for
5%
10%
15%
20% 25% 30% 35% 40%
European universe
Number of respondents
Figure 1: Breakdown of alternative multi-managers by number
Source: Edhec European Alternative Multi-management Practices Survey, December 2003
investing in hedge funds. By their capacity to mutualize an
investment process that requires very specific skills, funds of
in hedge funds, and direct investors in hedge funds who have
hedge funds have positioned themselves as the most optimal
similar preoccupations to FoHF managers.
way for institutional investors to access pools of hedge funds.
The breakdown by country in the sample corresponds fairly
Edhec Risk and Asset Management research centre has been
well to the breakdown of the firms that compose the alterna-
carrying extensive research on alternative investments,
tive multi-management landscape, notably as far as the domi-
notably in the areas of risk management and multi style,
nance of the U.K. and Switzerland is concerned (see Figure 1).
benchmarking and indices, and multi class asset allocation.
With this survey, we intended to bring to the industry the
We do, however, note that answers from French asset man-
results of our numerous research programmes and attempt to
agers are overrepresented in comparison to their weight
analyze the gap between current industry practices and the
among the leading firms. This can be explained by higher
most recent research in the area of alternative investments.
return rates to our questionnaires, as it was issued by a French
institution.
A pan-European initiative
In the summer of 2002, questionnaires for the Edhec
Figure 2 represents the breakdown of our respondents with
European Alternative Multi-management Practices Survey
regard to their average assets under management. We can
were sent to the top 500 European asset managers, alterna-
note that 26 respondents (42% of the sample) manage more
tive multi-managers, and institutional investors. The purpose
than € 1billion, which is not inconsistent with the fact that the
of the study was to get a better understanding of multi-man-
50 largest FoHF manage 90% of global assets2. Our sample
agement market within Europe. The study generated respons-
does not therefore suffer from any size bias.
es from 61 European alternative multi-management companies, representing a total volume of € 136 billion of alternative
assets under management at 31/07/02. It is important to note
Facts and figures on the European alternative
multi-management market
that our sample covers a wide variety of actors that are not
Traditionally, the sales arguments for alternative multi-man-
usually included within surveys on multi-management prac-
agement were based on absolute performance and the supe-
tices, such as Funds of Hedge Funds (FoHF) managers who are
riority of alternative alphas. This strategy led multi-managers
actually marketing FoHF products, advisors to direct investors
to propose diversified funds using the best managers.
2 ‘Asset Management Focus’, Freeman & Co., Q1 2003
108 - The
they wish to guard against within a multi-style/multi-class
AUM> 10 bn €
4%
5 bn € <AUM< 10 bn €
4%
diversification logic. As such, 64% of the professionals surveyed do offer FoHF by strategy today. Moreover, the relativizing of alternative performance has given rise to the creation
1 bn € <AUM< 5 bn €
18%
250 Mio € <AUM< 1 bn €
18%
of a large number of hedge fund indices. These indices, which
are created from funds, the most widely used being HFR
(27%), CSFB (27%) and Zurich (13%), unavoidably present
AUM< 250 Mio €
17%
0%
5%
10%
15%
20%
serious problems due to their lack of representivity and the
biases of the data used, resulting in potentially severe inconsistencies (See Figure 3).
Figure 2: Breakdown of respondents by size
Finally, in a desire to respond to a demand for benchmarked
investment management, a significant number of multi-man-
While these offerings are still present in the European market,
agement firms propose ‘investible’ indices. The criteria for
they have nevertheless been giving way progressively, over
constituting these indices are not based on representivity, but
the past three years, to a more relative approach to alterna-
on performance, liquidity, or fund availability.
tive performance which corresponds more to the concerns of
institutional investors, who are devoting an increasing share
This confusion between FoHF and indices is not conducive to
of their assets to hedge funds for diversification reasons and
objective measurement of performance and risks in the alter-
for the quality of their betas.
native universe and, as such, has led Edhec to propose hedge
fund indices of indices whose principles and construction tech-
This ‘beta benefit’ logic has led the alternative multi-manage-
nique guarantee better representivity and purity. More globally,
ment industry to offer FoHF by strategy, which allow investors
the poor quality of the data available leads operators to imple-
to choose the risks to which they wish to be exposed and those
ment private solutions (managed accounts, external risk
Investment Styles
Max differences
Date
Indices and corresponding returns
7,55%
Dec 01
EACM (-6.93%)
vs.
Hennessee (0.62%)
CTA
5,09%
Feb 99
CSFB (-0.54%)
vs.
HF Net (4.55%)
Distressed Securities
6,99%
Feb 00
EACM (1.23%)
vs.
Zürich (8.22%)
Emerging Markets
19,45%
Aug 98
MAR (-26.65%)
vs.
Altvest (-7.20%)
Equity Market Neutral
5,00%
Dec 99
Hennessee (0.20%)
vs.
Van hedge (5.20%)
Event Driven
5,06%
Aug 98
CSFB (-11.77%)
vs.
Altvest (-6.71%)
Fixed Income Arbitrage
10,48%
Oct 98
HF Net (-10.28%)
vs.
Van Hedge (0.20%)
Funds of Hedge Funds
8,01%
Dec 99
MAR (2.41%)
vs.
Altvest (10.42%)
Global Macro
14,17%
Oct 98
CSFB (-11.55%)
vs.
Altvest (2.62%)
Long/Short Equity
22,04%
Feb 00
EACM (-1.56%)
vs.
Zürich (20.48%)
Merger Arbitrage
2,71%
Sept 01
EACM (-4.32%)
vs.
HF Net (-1.61%)
Relative Value
10,47%
Sept 98
EACM (-6.08%)
vs.
Van Hedge (4.40%)
Short Selling
21,13%
Feb 00
Van Hedge (-24.30%)
vs.
EACM (-3.17%)
Figure 3: Maximum monthly return differences by investment style (from January 1998 through July 2003)
Source: Edhec Risk and Asset Management Research Centre
109
control system, thorough due diligence, etc.), with their cost
the Hennessee Group), into reality? Although the right quanti-
favoring consolidation of the market around the major players.
ty of hedge funds in a portfolio, according to various profes-
The latter are capable of coping with the requirements of
sional and academic studies, is between 15 and 25%, depend-
institutional investors in the area of transparency and in
ing on the strategies and risk profiles desired by investors, it is
controlling the risks of investing in hedge funds. Today, the 25
curious to note that a large number of institutional investors
leading FoHF represent almost 70% of alternative multi-man-
limit their share of hedge funds to 5% of their allocation. And,
agement.
clearly, 5% of hedge funds in a portfolio do not change its profile.
A summary of the major trends in the alternative multi-management market would not be complete if we did not mention
To answer this question, Edhec investigated the current
the development of structured products, which constitute a
European alternative multi-management market and analyzed
major innovation for the distribution of FoHF. Structured prod-
the responses of the professionals according to the three
ucts allow private or institutional investors to be offered a cap-
areas of a multi-manager’s value-added, asset allocation and
ital guarantee when faced with the extreme risks to which
portfolio construction, fund selection, and reporting and
hedge funds are exposed.
investor information.
Unlike structuring on traditional investments, the structured
Asset allocation and portfolio construction
product offering aims less to protect the investor from market
While diversification is the leading motive for investing in
risk than from the risk of the investment management itself. It
hedge funds, its seems that European FoHF do not wholly take
thus favors the marketing of FoHF to investors who are con-
into consideration the diversification potential of the different
cerned about the quality and security of their counterparty.
hedge fund strategies in their portfolio construction strategy.
In addition, structured products very often provide a solution
Figure 4 shows that 42% of the respondents offer funds with
to getting round the regulatory difficulties that hinder the
specific diversification objectives defined in relation to other
marketing of investment vehicles that are located offshore or
asset classes. While, for example, 80% of British alternative
cannot satisfy the criteria laid out by the European regulators
multi-managers offer FoHF by strategy, only 40% propose
for managing or holding funds.
funds that satisfy precise diversification criteria. Multi-managers’ lack of attention to the diversification properties of
The question of the value-added of alternative
multi-managers
hedge funds is probably linked to the confusion that exists
The main question the Edhec survey is trying to answer is vol-
value-added of the FoHF, and those relating to allocation or
untarily provocative and of a nature to give rise to debate.
diversification by style.
between the fund selection tasks, which constitute the original
Why, in spite of their undeniable diversification qualities, do
hedge funds represent less than 5% of the assets of institutional investors?
7%
Yes
No
7%
42%
No, but will soon
No aswer
More specifically, do FoHF, who hold themselves out as the
natural gateway to alternative investment, provide sufficient
44%
value-added to convince investors to transform their investment desires (89% were considering investment through
FoHF before the end of 2003, according to a recent study by
110 - The
Figure 4: Do you offer FoHF with specific behavior or diversification objectives in
relation to other asset classes?
80
70%
70
65%
60%
60
50%
50%
47%
50
40
55%
41% 40%
40%
40%
40%
35%
35%
29% 30%
30
30%
30%
29%
24%
22%
22%
20
0
10%
10%
10
6%
Sum of the best funds
selected
5%
0%
0%
Equally between the
different styles, categories
or strategies
Based on the correlation
between each
of the styles
Taking into account
the correlation between
the funds
Quantitative
optimization technique
Qualitative approach
based on scenarios
Figure 5: How do you construct your portfolios for multi-strategy or multi-style funds?
Source: Edhec European Alternative Multi-management Practices Survey, 2003
France
Switzerland
No answer
United Kingdom
Rest of Europe
While a significant majority of European FoHF (75%) have a
and increased their extreme risks. Finally, both observation of
team dedicated to portfolio construction and/or return fore-
the market and the comments of the multi-managers
casts for hedge fund styles, one cannot help but observe that
approached conclude that inter-style tactical allocation offer-
numerous European multi-managers continue to confuse
ings based on the predictability of hedge fund styles have
portfolio allocation with the choice of the best managers
experienced little growth. It is probable that the growing suc-
(22%). Only 13% combine a quantitative approach with a qual-
cess of alternative index trackers will, in time, encourage the
itative portfolio construction approach, even though it is the
setting up of offerings of that kind.
only method that allows scenarios on extreme market conditions to be taken into account while at the same time disci-
Fund selection and due diligence
plining and formalizing the manager’s intuitions.
While most alternative strategies exhibit abnormally distributed returns, the vast majority of hedge fund selectors con-
65% of European multi-managers do not use a quantitative
tinue to use tools from traditional investment management to
approach in the area of strategic portfolio allocation, despite
evaluate their performance. 82% consider the Sharpe ratio
the benefits of such approaches being highlighted by academic
and only 4% calculate an Omega ratio, despite the fact that
research. Only 47% of the professionals questioned take the
the latter is more appropriate for the alternative universe (See
correlation between funds into account to organize the diver-
Figure 6).
sification of their portfolio (See Figure 5).
The performance databases play a central role for 67% of the
More worryingly, in spite of the crises in 1998, only 13% of
participants, even though these databases contain numerous
European multi-managers have integrated an extreme risk
biases and it is easily shown that the choice of a database, and
measure and scenarios on extreme market conditions into
thus the choice of particular biases, influences the perform-
their portfolio construction process.
ance of the funds selected.
We also note that the vast majority of FoHF (76%) include
In spite of these data problems, 44% of the respondents give
more than 15 funds in their portfolio, even though all the aca-
quantitative analysis a significant role in fund selection, even if, in
demic and empirical studies have shown that beyond 10 or 15
the end, the weighting accorded to the analysis does not exceed
funds, depending on the strategy, the increase in the number
37% on average. If a majority of respondents internalize their fund
of underlyings made the FoHF lose their diversification qualities
selection process, it is interesting to note that one third of
111
Total Europe
Very
Important
Important
Not very
important
Not
considered
Sharpe Ratio
Sortino Ratio
M2 or SRAP Ratios
Drawdown Ratio
Return/VaR
Information Ratio
Return
Semi-deviation
Historical Sharpe ratio data
Tracking error ex-ante
Correlation
Standard deviation
Beta
Alpha
Omega
B VaR
Skewness & Kurtosis
BULL/BEAR
Rolling 3 year annualized returns
Recovery Time
35%
18%
2%
47%
24%
27%
5%
4%
4%
4%
4%
5%
4%
4%
2%
2%
2%
2%
0%
4%
47%
40%
13%
33%
35%
22%
0%
0%
0%
2%
4%
0%
2%
2%
2%
0%
0%
0%
2%
0%
11%
11%
27%
9%
15%
18%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
5%
25%
51%
5%
22%
29%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
80%
70%
Figure 6: Which quantitative indicators do you use when monitoring manager performance?
76%
60%
50%
40%
30%
20%
20%
13%
10%
0%
5%
Internally
By partially subcontracting due dilligence
By subcontracting
due dilligence
No answer
Figure 7: How do you select managers?
76% of FoHF do not set up ‘managed accounts’, regardless of
the amount of assets entrusted to the managers selected.
respondents outsource the selection partially or fully (See Figure 7).
More generally, we could set out the problem of the economEuropean multi-managers highlight detailed, qualitative
ics of the profession of alternative multi-manager. Projecting
analysis of fund operations in their selection and monitoring
the costs of a due diligence process cannot be sustained by
process.
FoHF with assets under management that amount to less than
U.S.$ 200 million, opening the path to external providers of
However, while this willingness is clear and unanimous, it does
services.
not always correspond to the reality of the means and procedures implemented, notably in the areas of due diligence and
Risk and performance reporting
risk monitoring. If we examine the hierarchy of criteria, it is
Being consistent with their fund selection process, multi-man-
curious to note that the quality of reporting and risk control of
agers favor mean/variance reporting rather than reporting
the underlying funds is essential in the eyes of the managers
that takes all the moments of return distribution into account.
who themselves do not always have tools or skills of that type.
For example, one-third of European FoHFs do not have a dedi-
Europe
cated team for risk analysis (See Figure 8).
Yes
It should be noted, in the same spirit, that, for want of a capac-
No
31%
ity to genuinely reassure themselves on the transparency of
the funds in which they invest, European multi-managers rely
69%
more on the reputation of their counterparty’s service
providers (prime brokers, custodians, auditors, etc.) than on
the operational analysis itself, notably for off-balance sheet
operations, which is not considered important or indeed not
taken into account at all by 27% of the respondents.
112 - The
Figure 8: Do you have a specialized risk analysis department?
120%
100%
100%
94%
90%
84%
80%
69%
60%
82%
70%
69%
50%
47%
40%
40%
30%
30%
20%
18%
20%
18%
VaR estimation
20%
20%
18%
16%
10%
0%
Volatility
measurement
22%
20% 20%
0% 0% 0%
Leverage effect
measurement
4%
Measurement of
the option characteristics of
fund returns
Figure 9: Which indicators and information do you use for reporting to your clients?
Total percentage exceeds 100% as answers were not exclusive
40%
30%
24%
10%
Sharpe ratio
62%
60%
59% 60%
10%
0% 0%
0%
Sortino Ratio
Conditional betas
France
Switzerland
Style analysis
United Kingdom
Europe
Comparison of
fund performance with a
benchmark made
up of indices that
are representive
of the strategy or
styles in which
the fund is
invested
4%
M2 orSRAP
ratios
0%
6%
7%
No answer
The Sharpe ratio (69%) is well ahead of the VaR (20%) or the
Conclusion
Sortino ratio (22%) among the indicators that are favoured in
What is clear from this study is that the current institutional-
the performance reporting of European FoHF (See Figure 9).
ization of hedge funds, and the move from absolute performance to diversification benefits, can not simply be understood
It should be stressed that volatility is considered by 84% of
as a change in scale and client objectives, but merely as a
multi-managers to be the major concern of their clients.
profound modification of investor’s requirements, impacting
However, this concern does not result in information on the
several dimensions of the industry:
diversification qualities of FoHF. FoHF are considered to be
volatility reducers not because they are exposed to interesting
risk factors within the framework of multi style/multi class
■ The need for the industry to adapt tools and methods
usually developed to serve the needs of long-only investors
diversification, but simply because they exhibit low volatility
to support the specific risks hedge funds are exposed to.
by themselves, even if this entails a magnification of extreme
■ The impact on the economics of the entire value model with
risks that are neither measured nor documented. Only 20% of
respondents give information on the leverage effect of the
fund. This insufficiency could lead to erroneous performance
the confirmation of funds of hedge funds as a main
provider of liquidity to investors.
■ The likely specialization of actors focusing on clearly
analyses, notably when a comparison with hedge fund indices
designated areas of added-value such as fund selection or
is carried out, which is the case for 62% of FoHFs.
asset allocation.
■ The need to take into consideration the constraints and
Finally, while studies on the failures of hedge funds have
minimum requirements for risk management infrastructure
shown that certification of their performance significantly
and superior due-diligence processes that are required to
reduced the failure rate, it should be noted that only 13% of
satisfy institutional investors’ desire.
the respondents have implemented certification by an independent third party.
These challenges are hitting the alternative multi-management industry as never before and will probably result in a
radically different landscape over the coming years.
113
Private equity
Private equity - An industry in transformation
Initial returns and long-run performance of private equity-backed
initial public offerings on the Amsterdam Stock Exchange
Leveraged management buy-ins: Role of investors, means of exit,
and the predictive powers of the financial markets
Private equity - An industry in
transformation
Tycho Sneyers
Head of Business Development, LGT Capital Partners
Private equity, or investments in private companies, experi-
first three to five years. On the contrary, a professionally man-
enced a significant inflow of capital during the late 1990s in
aged private equity program, with a significant allocation to
Europe. In the mid-1990s, most of the capital flowing into
secondary transactions, i.e. buying private equity funds that
European private equity came from large U.S. corporate and
share interests from existing investors, can generate signifi-
public pension funds, endowments, and foundations that ben-
cant distributions in the initial two to three years of a portfolio.
efited from successful private equity transactions in Europe
However, the limited liquidity in private equity still requires a
over the previous decade. Most European institutional
long-term investment horizon.
investors entered into private equity only in recent years.
Initial investments in private equity in Europe were made by
Attractive returns
U.K. investors, followed by Scandinavian and Swiss investors.
Investors benefit from the liquidity premium (the excess
Today, private equity investing is on the radar screens of most
return over public equities due to the restricted liquidity),
major European institutional investors, with an estimated
which can be achieved through private equity investing over
58% of the European pension funds participating in this asset
the long-term. Over the past 20 years, private equity invest-
class1.
ments have achieved an average net return of 15% per annum.
Private equity can be broadly divided into buyouts and ven-
Due to the downturn in the equity markets over the past cou-
ture capital. While buyout deals are characterized by the pur-
ple of years, institutional investors in Europe are eager for
chase of established companies with stable cash-flows, ven-
diversification alternatives to improve the long-term
ture capital investments target start-ups and companies in the
risk/return profile of their portfolios, with private equity
initial phases of their development. Unlike the average public
investments being one of the preferred options. Currently, the
stock portfolio, in private equity, there is a significant per-
average strategic allocation of Continental European and U.K.
formance gap between top and bottom quartile funds. While
pension funds to private equity is 4.2% and 3.6%, respective-
top quartile fund managers can achieve over 30% returns per
ly. This is still significantly lower than the average strategic
annum, lower quartile managers may not even return the
allocation of U.S. pension funds to private equity of 7.5%.
invested capital. This is primarily due to the wide differences
There are several reasons for the difference. Firstly, Europe
in private equity fund manager experiences, breadth of net-
has seen a slower development of its stock markets, which are
works to source the best investment opportunities, opera-
an important platform for exiting private investments.
tional and financial value creation during the holding period,
Secondly, the rigid regulatory and fiscal environment in
and successful execution of a selective sales process in an
Europe has been a challenge to the private equity industry.
inefficient market. Private equity is a highly skill-based asset
Thirdly, European pension funds have a preference to gener-
class (Figure 1). A successful private equity manager does not
ate an annual fixed interest return. This is mainly due to the
only participate in a less efficient market than a public equity
long history of investing a significant portion of their assets in
manager, but also must utilize an exhaustive strategic, opera-
government bonds and the fact that after the dramatic down-
tional, and financial toolkit during the investment process in
turn in the public equity markets, investments in bonds put the
order to generate value. As a result, a new or established team
least strain on the pension reserves. And lastly, European
that does not master this toolkit can very quickly destroy
investors have a much higher allocation to real estate invest-
value for investors. This is exactly what happened during the
ments than U.S. investors, an investment class which like pri-
period 1998 to 2000 when a number of new and established
vate equity is typically unlisted.
private equity managers were overwhelmed and unprepared
for the massive inflow of capital.
Contrary to common belief, an investment in private equity
does not mean that the performance will be impaired over the
1
116
Source: Alternative Investing Report 2003, Goldman Sachs/Russell
To partly mitigate the risk of write-offs, private equity alloca-
■ Direct investment in companies - This is the same invest-
tions should be diversified across a portfolio of 15 to 20 private
ment method employed by the private equity funds.
equity managers. Manager diversification should be imple-
It requires a specific skill set and an experienced team,
mented across geographies, vintage years, and investment
which only few institutional investors have in-house.
strategies.
Therefore, this approach is not suited for most investors.
Market based strategies
Skill-based strategies
■ Direct investment in a fund - This option requires detailed
know-how and dedicated resources for evaluating the
investment opportunities and selecting the managers. New
Upper quartile
Long-term return
private equity funds are raised about every three to four
years and typically invest in 10 to 20 companies.
This diversification reduces the investment risk. However,
Median
the manager risk which the investor faces remains
unchanged. There are more than 3000 funds in the
Lower quartile
Fixed income
Equities
investable universe on a worldwide basis. As such fund
interests can also be purchased on a secondary basis, the
investor faces a complex universe of investment opportunities from which to select. Some investors can have the
Figure 1: Skill based versus market based strategies
knowledge to select the best private equity funds out of
those based in the same country or area. This could work
Private equity investment options
well only for a small part of the private equity allocation,
There are 3 options for a private equity investor to invest in
given that it is crucial to select the best funds independent
this asset class (Figure 2), with each option offering a differ-
of their location.
ent risk-return profile:
■ Investment in a fund-of-funds - Fund-of-funds pool the
assets of several investors and deploy them over three to
Investors
Fund-of-funds
Private equity funds/
partnerships
Participations
in companies
five years into approximately 15-20 private equity funds. Up
until the mid-1990s there were only 20-30 fund-of-funds
providers, of which some already started investing in the
1980s and were able to generate returns of over 20% p.a.
During the late 1990s, as capital for investing became
abundant, the number of fund-of-funds providers increased
significantly, to over 80 worldwide. However, many of these
newcomers were missing some critical success factors,
such as an international investment team, a disciplined
investment process, as well as access to top-tier funds.
Today, as only few fund-of-funds providers possess the
Figure 2: Private equity investment options.
necessary resources and skill set, and as most of the capital
goes to those established and successful fund-of-funds
managers, the fund-of-funds industry is going through a
117
consolidation process which will reduce the amount of
competitors to below 50. Aside from a few globally
oriented players, most of the providers are operating in a
specific niche, pursuing strategies such as European buyout
or U.S. venture capital investments.
Private equity can be a source of portfolio diversification and
performance enhancement. However, in order to achieve
these positive attributes, it is important to have a focused and
diligent approach and build the private equity allocation overtime with a systematic and long-term perspective. Most institutions in Europe that manage more than €1 billion (approximately U.S.$ 1.25 billion) have already begun investing in private equity during the past 5 years, and have experienced varied degrees of success. Moving forward, many institutional
investors will have to refine their approach, avoid market timing, and invest throughout the cycles. And how they invest, be
it with an in-house team that invests directly in funds or via a
fund-of-funds, it is an important decision that has to be in line
with the internal resources and skills.
118 - The
119
Private equity
Ruud A.I. van Frederikslust
Associate Professor of Finance, Rotterdam School
of Management, Erasmus University Rotterdam
Initial returns and
long-run performance
of private
equity-backed initial
public offerings
on the Amsterdam
Stock Exchange
Roy A. van der Geest
Mergers and Acquisitions Consultant,
Holland Corporate Finance
Abstract
This paper investigates the initial returns and long run performance of initial public offerings (IPOs) using a sample of 38
private equity-backed IPOs and 68 non-private equity-backed
IPOs in the period 1985-1998 on the Amsterdam Stock
Exchange. We find that private equity-backed firms outperform non-private equity-backed firms. In tests using several
comparable benchmarks, private equity-backed firms show
less underpricing than non-private equity-backed firms, however the difference is not significant. The evidence suggests
that private equity-backed IPOs do not significantly underperform over a three-year period, while non-private equitybacked IPOs do. This paper also provides initial evidence on
the sources of underpricing and underperformance. Evidence
is presented that the reputation of the lead manager and the
age of the firm have a negative effect on the level of underpricing and that the sales growth rate has a significant positive
effect on the long-run performance of IPOs.
121
This paper investigates the initial returns and long-run per-
of existing asymmetric information, it is more difficult for an
formance of initial public offerings (IPOs) using a sample of 38
investor to get a reliable impression of the real value of the
private equity-backed IPOs and 68 non-private equity-backed
share price at introduction. To interest investors in the offer-
IPOs in the period 1985-1998 on the Amsterdam Stock
ing share, the share will have to generate a positive return in
Exchange.
the first days after its initial offering.
Private equity is defined as risk-carrying capital invested in
Almost all explanations of the influence of private equity funds
privately held companies. The investment mainly takes place
on the performance of the IPO firm in the short run are
through participation in the shareholders’ capital of the firm.
derived from the certification hypothesis. This hypothesis
Private equity contains both venture and non-venture capital.
states that the involvement of a private equity fund at a stock
The process of private equity investment starts with the selec-
introduction has a certification effect concerning the quality
tion of investment opportunities. After the private equity fund
of the introduction fund. Certification has economic value only
has optimized and managed the firm’s financial and opera-
if there is a discrepancy between the perceptions on the value
tional performance during its investment horizon, the partici-
of the company by insiders and outsiders. We consider insid-
pation is eventually divested. Generally, the private equity
ers to be management and other parties that have a profound
fund benefits from an increase in the equity value of its port-
understanding of the company, and outsiders as the (poten-
folio company at the moment of divestment.
tial) investors. Insiders are likely to conceal information that
may be harmful to the reputation of the company. Negative
There are several possible exit-routes, such as reselling to the
information will cause investors to adjust their perception of
firm or the management, reselling to a financial or a strategic
value downward. The total proceeds of the IPO are likely to be
party, and taking the firm to the stock market. The perform-
higher when negative information is successfully suppressed.
ance of companies divested by means of an IPO is analyzed in
this article. The article is organized into the following sections.
Rational investors realize the possibility to hide negative pub-
In Section 2 the theoretical and empirical background on the
licity and will discount the presence of hidden information in
performance of IPOs is discussed. The sample data and
their valuations. Therefore, investors are unwilling to pay high
methodology are presented in Section 3. Section 4 provides
average prices for IPO shares. This can be avoided by assuring
empirical findings concerning the short-run and long-run per-
investors that all relevant information is disclosed. Investors
formance of private equity backed (PEB) and non-private equi-
are more likely to believe that all information is disclosed
ty backed (non-PEB) initial public offerings, as well as initial
when a third party that has no direct stake in maximizing the
evidence on the sources of underpricing and underperfor-
proceeds of the IPO, is involved in the IPO. This certifying func-
mance. Section 5 concludes the paper.
tion will reduce the information asymmetry between insiders
and outsiders of the firm. Reduced information asymmetry
122 - The
Theoretical and empirical background on the
performance of IPOs
will lead to less underpricing.
Underpricing
There are three conditions that have to be met in order for the
Underpricing is the positive return that a shareholder can
third party to be able to perform a certifying role successfully.
achieve when a newly public share is bought at its offering
The first is that the certifying party has to have its reputation
price and sold at its first closing day-price. Almost all theories
at stake when an IPO is overpriced. Secondly, the loss of a
of underpricing assume an ex-ante uncertainty for sharehold-
good reputation has to outweigh any possible monetary
ers concerning the quality of IPO firms [Rock (1986)]. Because
reward of a false certification. The third condition is that a firm
hiring a third party to certify should incur considerable costs
Underperformance
doing so. Moreover, third party services cannot be easily
Underperformance is where the long-run return of the new
replicated.
public company has a lower performance than the benchmark.
Studies in numerous countries have confirmed underperfor-
Private equity funds tend to meet these conditions. The well-
mance after one [Aggarwal and Rivoli (1990)], three [Ritter
established private equity funds are frequently involved with
(1991) and Loughran et al., (1994)] and five years [Loughran
IPOs, and profit from good and long-term investor relations.
and Ritter (1995)].
Successful private equity funds have access to a large investor
market, and are attractive investors to companies that aspire
Brav and Gompers (1997) investigated the long-run return for
to go public in the future. Private equity funds are unlikely to
private equity-backed (PEB) and non-PEB initial public offer-
be willing to jeopardize their relationships for a onetime mon-
ings. They proved that the PEB public firms perform better
etary benefit of a false certification. Moreover, they require
than the non-PEB ones. Evidence is presented that the book-
return on investments for services rendered. These services
to-market ratio at offering-date has a significant influence on
may include providing the invested amount of money, man-
the aftermarket performance. Munsters and Tourani Rad
agement and technical expertise, improved access to capital
(1994) have examined the performances of PEB and non-PEB
markets, and the certifying role when going public.
initial public offerings. Contrary to the above-mentioned
research, they find that this does not hold for the Netherlands,
Barry et al. (1990) and Megginson and Weiss (1991) examined
as in the Netherlands PEB initial public offerings underper-
the certification hypothesis for the American market. They
form non-PEB initial public offerings. Carter et al. (1998) not
found that the involvement of a private equity fund at the IPOs
only examined the lead managers’ short-run influence, but
leads to less underpricing. Munsters and Tourani Rad (1994)
also studied their long-run influence. IPOs by ‘better’ lead
have been unable to determine this certification effect for
managers show less underperformance.
IPOs in the Netherlands.
Aggarwal and Rivoli (1990) attribute underperformance to a
The described certification hypothesis can also be applied to
temporary overvaluation of the IPO firm at the offering date,
the role of the lead manager. Carter et al. (1998) find evidence
the so-called ‘fads’ theory. After a while the over optimism dis-
that IPOs which have been introduced by lead managers hav-
appears and the value of the new share will be downwardly
ing a good reputation show less underpricing.
adjusted. Ritter (1991) has further advanced the fads theory
and showed that IPO firms with a high risk profile (i.e. younger,
Stoughton and Zechner (1998) suggest that underpricing is
smaller, and active in certain sectors) are sooner subject to
the result of moral hazard, which means that underpricing is
shareholder sentiment; the so called fads of the stock market.
compensation for the monitoring activities conducted by (larger) professional shareholders. Schultz and Zaman (1993) indi-
Loughran and Ritter (1995) find evidence that underperfor-
cate that the amount of underpricing results from the difficult
mance is the result of the utilization of ‘windows of opportu-
balance between maximization of revenue from the introduc-
nity’ by the issuer and the lead manager. Companies go public
tion for the issuer of the shares and a positive return for
at the moment of relative overvaluation, i.e. a high market-to-
investors. Eijgenhuijsen (1989), Van Hoeijen and Van der Sar
book ratio. If, after a while those firms do not live up to their
(1999), and Loughran and Ritter (1994) show that the offering
expectations, the value will be adjusted downwards. Teoh et al.
method of the IPO has an effect on the level of underpricing.
(1998) suggest that companies who are guilty of window
dressing, just before going public, show more underperfor-
123
mance in the aftermarket. Based on the provided information
Characteristic
Total
Non-PEB
PEB
T-value
N
IPO method
Fixed
Flexible
Lead manager
ABN AMRO Bank
MeesPierson
ING Bank
RABO Bank
Kempen & Co.
Average Age
Average Market value (Euro)
106
68
38
68
38
40
28
28
10
42
23
6
6
5
45
305,812,073
27
13
5
3
5
47
415,267,074
15
10
1
3
0
41
0.746
109,945,228 1.889 a
90,001,046
0.38
115,078,494
0.42
45,125,614
0.33
investors initially overvalue the issue. If the company is not
able to fulfill the expectations after going public, investors will
revalue their positions, which will cause the stock price to fall.
In this article, an attempt is made to provide clarity about the
above-mentioned contradiction between the short-run and
long-run performances of private equity-backed IPOs on the
American and Dutch stock markets.
Data and methodology
Sample selection
Average offering value (Euro)
Book-to-market ratio
a
We investigate the performance of initial public offerings on
the Amsterdam Stock Exchange using a sample of 38 private
equity-backed and 68 non-private equity-backed IPOs during
the period 1985-1998. Several criteria are used to select our
sample firms. IPOs of investment funds are excluded from the
sample because their unique characteristics make them
incomparable with other IPOs. IPOs that are the result of a
‘reverse takeover’ are excluded. Inclusion is also reserved to
those IPOs of which an issue prospectus was available (information involving possible private equity backing is traceable
1.386
1.253
Significant at a 10% level
Figure 1: Description of the sample firms
Figure 1 shows the descriptive details of the sample of 106 IPOs in the period 19851998 on the Amsterdam Stock Exchange. Non-PEB refers to initial public offerings,
which had no private equity backing. PEB IPOs are those with private equity backing.
The IPO methods are categorized into whether an introduction had a fixed offering
price or was brought to the market through a flexible method. The flexible method
includes claim, tender, and bookbuilding. Market value is the total amount of fully
paid for shares from the introduction multiplied by the first closing price.
The offering value is the total amount of issued and reinvested shares multiplied by
the offering price. Book to market signifies the ratio between the book value of
equity and the market value of equity on the basis of the first closing price.
The t-value is the statistics for the difference between the non-PEB and PEB initial
public offerings in the sample.
trough this source). A sample of 106 market introductions
Long-run return
remained and were used to calculate the short-run return.
Underperformance is determined by calculating cumulative
Based on the information gathered from the issue prospec-
abnormal returns (CAR) and the wealth relative factor (WR)
tuses, 38 initial public offerings were private equity-backed
[Ritter (1991)]. For this purpose 75 initial public offerings in the
and 68 were not. Figure 1 reports several characteristics of the
period of 1985 till 1995 were used. Of these 75 companies, 28
PEB and non-PEB initial public offerings in the sample.
received private equity backing and 47 did not. To incorporate
the effect of market tendencies the CBS all shares index, the
From the data in figure 1, it can be concluded that PEB IPOs are
CBS all shares index minus Royal Dutch Petroleum, and the
generally related to smaller introductions of younger and
AMX index were used as benchmarks. If a share is delisted, the
smaller companies (with regards to market value) with a lower
portfolio’s return for the following months are equally divided
book-to-market ratio than non-PEB initial public offerings.
among the remaining funds. During the investigated period
five funds were delisted.
Short-run return
To determine the level of underpricing for 106 IPOs from 1985-
A CAR-value of 12 percent signifies that the portfolio with n ini-
1998, the initial (abnormal) return is calculated. To calculate the
tial public offerings over a period of s months underperformed
market return for the same period the Central Bureau of
the benchmark by 12 percent. In addition to CAR, the wealth
Statistics (CBS) share price index and the Amsterdam Exchange
relative ratio was used to evaluate the aftermarket perform-
Midcap (AMX) share price index are used as benchmarks.
ance [Ritter (1991)]. The return of the initial public offering is
calculated assuming a buy-and-hold investment strategy. This
124 - The
0.400
Short-run return
Total
N
initial Return (IR)
106
0.16 a
Abnormal Return 1 (AR1)
Abnormal Return 2 (AR2)
0.16 a
0.16 a
a
non-PEB
PEB
68
38
0.17 a
0.17 a
0.18 a
0.13 a
0.13 a
0.13 a
T-value
0.300
0.921
0.938
0.946
Significant on a 1% level.
Figure 2: Initial and abnormal returns
0.200
0.100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Figure 2 shows the initial and abnormal returns for the sample of 106 IPOs in the
period 1985-1998 on the Amsterdam Stock Exchange. The average initial return (IR)
is the uncorrected return during the first day of trading. The abnormal return 1 (AR1)
is the initial return corrected for the return on the CBS market index. The abnormal
return 2 (AR2) is the initial return corrected for the return on the AMX market index.
A t-test was done with the null hypothesis that the mean of IR, AR1 and AR2 is zero.
The results of this test are shown with the means. A t-test was also done with the
null hypothesis that the mean of IR, AR1 and AR2 are the same for PEB and
non-PEB initial public offerings. The t-value is shown in the fifth column.
investment strategy presumes that an initial public offering is
0.100-
0.200CR
CAR1
CAR2
CAR3
Figure 3 shows the aftermarket performance of 75 IPO in the 36 months after the
initial offering date. The returns do not include the initial return. CR represents the
cumulative average raw return. CAR1 uses the market weighed CBS index as a benchmark to determine the aftermarket return. CAR2 is calculated as CAR1 with the exclusion of Royal Dutch Petroleum from the CBS index. CAR3 uses the market weighed
AMX index as a benchmark to calculate the aftermarket return
received at the first closing price and is kept in the portfolio
over a period of s months. The average return of the benchmark is determined in the same way as the average return of
0.400
0.300
the portfolio. A WR-ratio larger than 1 implies that the IPO
firms outperformed the benchmark.
Empirical findings
Underpricing
0.200
0.100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Figure 2 presents the short-run returns for the full sample,
non-PEB and PEB IPOs. The average initial return on day 1 for
the full sample is 16 percent. Adjusting the initial return for
0.100-
0.200-
market movements does not result in a different figure. From
the data in Figure 2, it can be concluded that the PEB introductions are less under-priced than the non-PEB initial public
offerings. Even though all three calculations of the return
show less underpricing for the PEB initial public offerings, this
0.300CR
CAR1
CAR2
CAR3
Figure 4 presents the aftermarket performance (excluding the initial return) of
47 IPOs not backed by private equity for 36 months after the IPO date.
difference is not significant. Therefore, contrary to the study
done by Megginson and Weiss (1991) on the American market,
reputation of the lead manager influences the level of under-
the certification hypothesis of private equity funds for the
pricing. Initial public offerings, which are accompanied by the
Dutch stock market, must be rejected.
most prestigious lead managers, cause the least ex-ante
uncertainty for shareholders and show the lowest level of
The influence of different variables on the level of the initial
underpricing. With market share as proxy for the reputation
return is investigated by means of linear regression. In line
class, it was assumed that the bigger the market share the
with the theoretical model of Rock (1986) and the empirical
better the reputation. The ABN AMRO (Rothchild) Bank has by
research done by Carter et al. (1998) it turns out that that the
far the biggest market share.
125
The number of years since incorporation also has a significant
influence on the level of underpricing of the IPO. Presumably,
0.500
0.400
older more established companies cause less ex-ante uncertainty for the shareholder and therefore show less underpricing.
Underperformance
Figure 3 plots the average cumulative abnormal return for 36
0.300
0.200
0.100
months after introduction excluding the return of the first
-
trading day.
The IPO portfolio achieved an average (not benchmark adjust-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
0.100CR
CAR1
CAR2
CAR3
ed) cumulative total return (CR) of 36 percent after 36
months. After adjusting the CR, the aftermarket performance
appears to be declining. Dividing the sample into PEB and non-
Figure 5 shows the aftermarket performance (excluding the initial return) of
28 IPOs backed by private equity over 36 months after the IPO date.
PEB initial public offerings provides different results. Figures 4
and 5 show the difference in performance. Based on the AMX
index there is significant underperformance during eleven of
the 36 months of the non-PEB initial public offerings compared to the PEB offerings.
Non-PEB
PEB
T-value
a
Figure 6 shows the wealth relative ratios of the non-PEB and
PEB initial public offerings. Again a difference between the
two sub-samples is found: the PEB initial public offerings outperformed the benchmark, while the non-PEB initial public
offerings showed underperformance. The difference between
the two sub-samples is statistically significant at the 10% level.
N
WR1
WR2
47
28
0.93
1.28
1.600 a
0.97
1.35
1.620
WR3
0.95
1.32
a
1.643 a
Significant at the 10% level.
Figure 6: Wealth relative ratio of PEB and non-PEB initial public offerings excluding
initial return
WR1 gives the wealth relative ratio with the CBS all shares index as the benchmark,
WR2 gives the wealth relative ratio with the total return buy-and-hold CBS minus
Royal Dutch Petroleum (Shell) index as the benchmark and WR3 gives the wealth
relative ratio with the AMX index as the benchmark. Total return is defined as
dividend yield plus capital gain yield
Based on prior studies of the performance of initial public
offerings a number of variables were tested with a regression
analysis of the buy-and-hold return of the initial public offer-
growing (promising) companies that use an IPO for expansion
ings. The variables were derived from the certification hypoth-
will have most likely, more up-side potential. Regarding the
esis, the ‘fads’ theory, and the ‘windows of opportunity’ theory.
average growth rate, the assumption is that companies that
realize a substantial sales growth in the years prior to public
Besides this ‘traditional’ set of variables, a number of new vari-
offering will continue to do so in the aftermarket, which will be
ables were introduced: offering motive and average sales
beneficial to the aftermarket performance.
growth rate for a two-year period prior to the IPO. If the IPO is
fully used for re-issuing existing shares, this indicates the
The analysis proves that ‘traditional’ variables from previous
cashing in of shares by ‘old’ shareholders. If the IPO is only
research provide no long-term explanations of the aftermarket
used to issue new shares this indicates the receiving of funds
performance of IPOs. The ‘new’ variables: private equity back-
to finance further expansion of the company. Younger and
ing, average sales growth, and the ICT industry show significant correlation with the aftermarket performance.
126 - The
Conclusion
increases the chances of PEB initial public offerings doing
The average initial return on day 1 for the full sample of 106
better in the aftermarket than those that were not backed in
initial public offerings is 16 percent. The 38 private equity-
this way.
backed IPOs show an average level of underpricing of 13 percent, the 68 non-private equity-backed IPOs 17 percent.
With the above mentioned research results, contrary to the
Despite the fact that the PEB sample showed less underprinc-
research by Munsters and Tourani Rad (1994) and in agree-
ing than the non-PEB sample and the certification hypotheses
ment with research by Brav and Gompers (1997) in America, it
seems to be confirmed, the difference between the two, is not
is shown that in the Netherlands private equity backing has a
significant.
positive link with the aftermarket performance of initial public
offerings.
The certification hypothesis of the lead manager could be
accepted. Initial public offerings that were accompanied by
To determine the effect of the variables on the aftermarket
prestigious lead managers show less underpricing.
performance a regression analysis was performed. This analysis shows that ‘traditional’ variables from previous research
After three years, 75 IPOs have an average underperfor-
provide no long-term explanations of the aftermarket per-
mance. If the sample is divided into two, it appears that the
formance of IPOs. The ‘new’ variables: private equity backing,
underperformance is caused by the non-PEB initial public
average sales growth, and the ICT industry show significant
offerings. The PEB initial public offerings perform better on a
correlation with the aftermarket performance.
structural basis. This holds true for the three-year return calculations, based on the cumulative average abnormal return
References
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long-run performance of IPO stocks,’ Journal of Finance, 53, 285-311
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het verschijnsel ‘underpricing’,’ Maanblad voor Accountancy & Bedrijfseconomie, 63, 119-127
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• Loughran, T., J. Ritter, and K. Rydqvist, 1994, ‘Initial public offerings: international
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offerings,’ Journal of Finance, 46, 879-903
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returns, using several comparable benchmarks.
A possible explanation for the outperfomance of private equity-backed IPOs compared to that of non-private equity-backed
IPOs is the phenomenon of ‘double selection’. Double selection refers to the investment and exit opportunity used by private equity funds. Private equity funds will in general only
invest in companies if there is enough potential to realize the
return objectives. In other words, the company will have to
meet the return objectives through the payment of dividends
and/or with an increased share price at the time of exit.
Apart from this, a private equity fund will only take the most
successful companies public. If a private equity fund frequently takes companies to the stock market, a certain perception
will be created with the shareholders with regard to the quality of these initial public offerings. To make sure that there is
enough interest (i.e. demand with the shareholders) a private
equity fund will only want to be identified with successful initial public offerings. Thus the phenomenon of double selection
127
Private equity
Leveraged
management buy-ins:
Role of investors,
means of exit, and the
predictive powers of
the financial markets
Shahin Shojai
Director of Strategic Research, Capco
Abstract
In this paper I empirically test whether the involvement of a
special type of investors can help improve the performance of
targets within leveraged management buy-in transactions. I
also test the market's ability in discriminating between those
management buy-in targets that fail or succeed subsequent to
going private and find that the markets are in fact capable of
predicting failures and successes at the time of the announcement of these bids. The results reveal that the involvement of
LBO-Associations improves the chances of post-transaction
success, and that MBIs that subsequently fail do not underperform their industrial peers prior to the bid, they were simply over-priced by the bidders. The bidding teams who boughtinto these failing MBIs, those which the market's deemed
unsuitable, were simply faced with the winner's curse and had
over-estimated their abilities in bringing about substantial
improvements within the management of these targets.
129
Ever since the major stock markets started their downward
be presented in this paper as a possible solution to today’s cor-
spiral and the many irregularities in company reports, over-
porate governance structures.
looked during the hype of the stock market boom, came to
light, the financial community has been looking at ways to
MBIs will be used in this paper to investigate primarily whether
improve how management is monitored. Many suggestions
the pre- and post-buy-in characteristics of those targets which
have been provided by corporate governance experts to
exit via bankruptcy or reverse-LBO (return back on to the pub-
ensure that such mis-reporting does not occur again. These
lic markets through a secondary IPO), as proxies for financial
solutions range from separation of the chairman’s role from
distress and prosperity respectively, could be determined and
that of the CEO to the establishment of independent board
secondly, whether the markets can distinguish between those
member selection procedures to requiring executives’ personal
that subsequently succeed or fail from the information avail-
affirmation that accounts are reliable. These are all very use-
able at the time of the buy-in announcement. Previous studies
ful solutions and should be implemented. However, they are
which have investigated the stock market's ability in predict-
now far too focused on monitoring, while their predecessors,
ing takeover targets, through the analysis of the pre-takeover
stock options, were too focused on incentives. Of course, now
stock price movement of target firms, [Dodd and Ruback
that the dust has settled, many are looking for governance
(1977), Asquith (1983), Palepu (1983)] have found that ‘it is dif-
structures that not only improve control, but also stimulate
ficult, if not impossible, for the market to predict future tar-
performance.
gets.’ [Jensen and Ruback (1983)]. What differentiates this
study from its predecessors, however, is its focus on the mar-
So, the question is, how can we establish a corporate gover-
ket's analytical proficiency in predicting the future prosperity
nance structure that achieves both objectives? Simply ensur-
of the differing targets, and not the likelihood of being select-
ing that managers do not lie about their company accounts is
ed as a target, from the information available at the time of
nothing more than expecting auditors to be independent.
the announcement3.
However unrealistic that may sound these days, there should
be more to improved corporate governance than simply look-
Using a sample of 127 management buy-ins (MBIs), announced
ing for fraudsters. In this paper we look at a special type of
and completed between 1980 and 1989, I empirically aim to
ownership structure that can achieve both objectives of
find answers to the following questions concerning MBIs and
improved monitoring and performance. These ownership
their assessment by the market:
structures occur as a result of corporate management buy-ins
(MBIs), transactions in which an external management team1,
with the help of private equity financiers and significant leverage, replace the incumbent management and take the company off the public markets. An important type of these transac-
■ Can the stock market differentiate between MBIs that will
subsequently prosper and those that will not? If not, are the
markets efficient?
■ What makes a target suitable? If the markets can
tions involve LBO-associations [Kaplan (1991)] who, analogous
discriminate between suitable and unsuitable targets, what
to the takeover specialists [Jensen & Ruback (1983)] within
factors allow this differentiation to be undertaken and why
the takeover market, punish management teams who are
deemed to fail in maximizing their shareholders' wealth by
buying into their companies and replacing them. The LBO-
is it that unsuitable targets are bought-in?
■ Can LBO-association consistently outperform their peers in
the post-transaction management of the target?
associations, as well as being involved in the structuring side
130
of these transactions, undertake to closely monitor the man-
Our results indicate that suitable MBIs do possess distinguish-
agement's actions2. It is the role of these types of investors will
ing characteristics and that the stock market is capable of
1
3 Our analysis is, therefore, analogous to the studies of the informational content of
dividend announcements [Lang and Litzenberger (1989)], where the markets
attempt to predict the future performance of a firm from the information
contained within its dividend announcements.
Please note that this is a group of managers, and not another company, as in the
case of acquisitions.
2 In this sense they are fundamentally reinstating the monitoring roles played by
the U.S. banks prior to the 1934 SEC Act, which significantly increased the costs of
such active involvement.
discriminating between those that will subsequently prosper -
the 'true' internal state of affairs, incoming managers may
those MBIs that revert back into public ownership (through a
only identify problems fully after they have completed the
Reverse LBO) within a few years of going private - and those
transaction. To the extent that these problems lead
that do not - MBIs that face financial distress4 within a few
managers (and their investors) to misjudge the situation,
years of going private. We also find that LBO-associations are
a deal and accompanying financial structure may be agreed
able to select the most suitable targets and ensure that their
which is inappropriate and possibly unviable. As a result,
performance is significantly improved post-transaction. The
the control mechanism introduced by the commitment to
markets are found to be able to make their judgments upon
meet the cost of servicing external finance may lead to
the suitability, or lack of, an MBI target within the first 24
sub-optimal decisions. Investors are also faced with an
hours subsequent to the announcement of intent on the part
adverse selection problem both in relation to managers’
of bidders.
capabilities and the state of affairs in the company.
■ As the transaction involves one single entity there are no
The rest of this paper is organized as follows: In the next section,
I will review the main attributes of MBIs and discuss the main
factors that can contribute to their success or failure. I will
potential synergy sources present [Weston et. al (1990)],
as is the case with some acquisitions.
■ MBI teams in preparing an initial bid rely solely upon
subsequently highlight the methodology used, present the
publicly available information and thus possess no signifi-
results of the study, and finally provide my conclusions.
cant informational advantage to the rest of the market5.
Specific characteristics of MBIs and the
rationale for their analysis in this study
These unique characteristics of MBIs make it possible, there-
Management buy-ins being hybrid transactions which possess
vis-à-vis the bidding teams. This type of comparison would,
some of the attributes of management buy-outs (MBOs), in
however, not be possible with either MBOs, where there is an
which the going private transaction is initiated and consum-
informational asymmetry between the internal bidders and
mated by members of the incumbent management, and tender
the rest of the market, or tender offer acquisitions, in which
offer acquisitions, where one organization acquires another,
the post-transaction performance of the target could be influ-
are bestowed with some of the potential sources of benefits
enced by other exogenous factors, such as synergies.
fore, to compare the analytical capabilities of the stock market
present in each. These include tax savings from asset step-ups
and interest deductibility, potential efficiency improvements
A characteristic shared by MBIs and MBOs is, however, the
from change in management structure and style, and mitiga-
very high levels of debt needed to finance both of these trans-
tion of agency cost.
action, which as well as generating large tax benefits, makes
them extremely risky [Myers (1984]. The market would look
MBIs can, however, be differentiated from both of these trans-
for higher debt capacities - associated with lower levels of
actions on the following grounds:
gearing, larger fixed asset portfolios, and greater levels of free
cash flows - and the degree to which the target's performance
■ The MBI teams, being outsiders, are not endowed with the
can be modified to cushion the effects of high leverage.
possession of asymmetric information, as are the
incumbent management [Myers and Majluf (1984)] within
Higher debt capacities and fixed asset portfolios
an MBO [Perry and Williams (1994)]. Incoming managers
Leveraged management buy-ins can take advantage of three
are faced with potentially severe adverse selection
sources of tax savings [for a deeper review of these please
problems. Whilst incumbent managers in an MBO may know
refer to Kaplan (1989a); and Schipper & Smith (1991)]. Firstly,
4 Financial distress is used to describe situations in which the firm has been unable
to meet its debt obligations (i.e. defaulted), attempted to restructure its debt, or
declared bankruptcy voluntarily (Chapter 11) or involuntarily (Chapter 7).
This information is obtained by monitoring the Wall Street Journal’s Index.
5 This is also legally reinforced by the Hart-Scott-Rodino Act 1976, which requires
bidders to divulge all the information at their disposal to the market. They are,
therefore, unable to legally benefit from the possession of private information.
131
the increased coupon payments, associated with the higher
equity capital onto the public markets [Mayer (1988)], the MBI
debt ratios, significantly increase the level of tax shield pro-
teams neither possess a firm to raise financing upon nor do
vided to the post-MBI firm. Secondly, the higher depreciation
they have any track record in managing the firm they wish to
rates allowed on the stepped-up assets reduce the taxable
buy-into. These MBI teams are, therefore, forced to turn to the
profit. Thirdly, there are potential tax benefits from MBIs in
debt markets for the necessary capital, with their livelihoods,
which the current employees of the target take over the man-
future prospects, and the underlying assets of the target firms
agement of the firm, through the use of ESOPs. The latter
as their collateral. Experience has shown that in a majority of
form of transaction has been removed from this sample due to
MBIs some of these underlying assets are sold, in the post-MBI
the information asymmetry that might exist between these
state, to reduce the heavy debt burden incurred during the
types of MBIs and those undertaken by an external group of
buy-in process [Kohlberg Kravis Roberts & Co. (1989)].
managers.
The MBI teams, as well as looking for those companies that
Although it is widely acknowledged that significant tax bene-
possess low gearing levels and large fixed asset portfolios,
fits accrue from going private, many reject Lowenstein’s
also look for those companies that generate large free cash
(1985, 1986) proposition that their exploitation is the most
flows which can be used to meet the interest payments on the
important motivation behind these types of transactions
large volumes of debt accrued. We would, therefore, expect
[Opler & Titman (1993)], primarily on the grounds that such
that those MBIs which subsequently fail possess none of these
large borrowings could also be undertaken while the firm is
advantageous features.
still public, as in the case of leveraged re-caps. Opler & Titman
132 - The
(1993), while proposing that LBOs allow firms to realize the tax
Efficiency improvements
gains from debt without the need to encounter the costs of
Jensen (1988) proposed that acquisitions are a mechanism by
financial distress associated with it, acknowledge ‘that there
which inefficient managers, i.e. those who fail to maximize
must be some non-tax-related motives for using debt in LBOs’
their firm's market value, will be replaced by new and poten-
such as the mitigation of agency costs, through the reduction
tially more efficient managers. Management buy-in transac-
in the level of free cash flows at the disposal of management
tions while also benefiting from the replacement of inefficient
and improved monitoring role played by the debt holders
management are not afflicted with the same managerialism
[those whom Fama (1985) refers to as the ‘financial special-
issues [Mueller (1969)] associated with some acquisitions. If
ists’]. They reached such a conclusion based on the earlier
the main goal of the buy-in team is also to rectify managerial
findings of Opler (1992), who found that many of the firms in
inefficiencies, their most suitable targets should be those that
his sample took on much more debt than was required to elim-
are underperforming their peers, since they possess the
inate their taxable earnings and that approximately 50% of
greatest potential for improvements6. In fact one would not
those same companies paid no income tax after going private.
expect a company which is not underperforming its industrial
Secondly, if the tax benefits of debt were the sole justification
counterparts to be selected as a target of a takeover or an MBI
behind LBOs, the degree of leverage would not have been
[Jensen and Ruback (1983)] since it should generally be able
reduced as significantly as they have been shown to be [Hite
to fight off the bid. Jenkinson and Mayer (1994) have found,
& Owers (1984)]. The justification behind such high leverage
however, ‘that there is little relationship between the financial
seems to be that debt remains to be one of the primary
performance of a target before acquisition and either the like-
sources of financing for these types of transactions. Unlike a
lihood of a hostile bid emerging or the outcome of that bid.’
tender offer acquisition in which the bidding firms can finance
They also find that when cash is the predominant means of
their acquisitive activities through the issue of additional
payment even bids for companies that are not underperforming
6 The incumbent management's inability to recognize the opportunity to sell-off
those divisions which do not fit in with the firm's overall structure to those that
have the highest valued use for them should also be viewed as a symptom of
managerial inefficiency.
have a high degree of success. They, therefore, find little asso-
these transactions took place. Out of these 127 buy-ins, 52
ciation between the success of the bid and the suitability of
firms remained private (MBI-PRIV), 31 reverted back into pub-
the target7. The fact that in a large majority of MBIs the pre-
lic ownership (REV-LBO), 12 faced financial difficulties
dominant means of payment is also cash, raised upon the
(FAILED), and 31 were acquired by third party investors groups
underlying assets of the target, means that many unsuitable
or firms (ACQUIRED). I find that 75% of those firms that failed
targets could also be bought-into.
did so during the post-1985 period. During the same period,
however, I find that as well as many failures there were also
But why would bidders bid for unsuitable targets? Roll (1986)
many success stories, REV-LBOs. Over 20% of those firms
proposes that many bidders might bid for unsuitable targets
that went private after 1985 reverted back into public owner-
because they tend to over-estimate their abilities to manage
ship within six years of going private, the median number of
the acquired entities better than they were prior to the acqui-
years the firms are private prior to reverting back into public
sition, a situation exacerbated by the fact that these external
ownership. Corroborating Jensen’s suggestions that the likeli-
bidders have to rely solely upon publicly available information
hood of LBO failures increased after 1985. The greater likeli-
when selecting their targets. This over-optimism might, as well
hood of failure post-1985 is surmised to be associated with the
as inducing them to select unsuitable targets, lead them to
very high level of competition between the newcomers, espe-
pay over and above what the target is really worth8. Such over-
cially junk bond investors who had less and less reputational
payments, within the MBI market, could lead to situations in
capital at stake and promoted deals which were even deemed
which the additional cash flows generated, from parts of the
precarious, which resulted in higher prices and lead to poten-
restructuring process being implemented successfully, might
tial over-payments. Delving deeper into the microstructure of
not be adequate to cover the much higher debt payments,
the successful deals, we find that, as Jensen (1991) had pro-
associated with the extra borrowing undertaken, and the firm
posed, the most realistic deals were done by those who had
might be forced into bankruptcy [Kaplan & Stein (1993);
the highest reputational capital at stake, i.e. the LBO-associa-
Wright, et al. (1995)].
tions. Over 70% of the successful buy-in deals were lead by an
LBO-association. Excluding these from the sample, one finds
Before we can judge whether the MBI teams do select unsuit-
that the likelihood of LBO-reversion is significantly reduced. It
able targets or not, we need to firstly investigate whether
could, therefore, be inferred that the likelihood of subsequent
there are any distinguishing characteristics which could be
failure is greater for those buy-ins which were lead by an aver-
used to discriminate between suitable and unsuitable targets,
age management team and undertaken after 1985.
and secondly, whether the stock market also has the ability to
identify these attributes.
Many might question the logic behind the decision to associate reverse-LBOs with the subsequent success of the LBO
Methodology
firm, since they might judge the decision to revert back into
In order to discriminate between suitable and unsuitable buy-
public ownership as evidence of facing difficulties. They might
in targets, I have compiled a list of 127 buy-ins announced and
deem that the firm is unable to meet its debt obligations and
consummated between 1980 and 19899, the period not afflict-
as a result forced to revert back into the public market in order
ed by the stock market speculative bubble and when most of
to raise equity [Kaplan (1991)] and reduce its leverage. I, how-
7 Many bidders justify their bids for non-underperforming targets on the grounds
that although the target's performance is not poor, it is still sub-optimal and could
be improved.
8 The likelihood of overpayment increases when the number of new and
inexperienced participants increases. Their influence upon the market would be to
reduce the number of attractive deals available and/or bid up the prices to competitive levels. For a deeper analysis of overpayment please refer to Jensen (1991).
9 For the purpose of comparability, each sample firm was matched with a control
firm. These control companies were generated through a four-step procedure. (1)
The first step was to collect the lists of all the companies within the same 4 digit
Standard Industrial Classifications (SIC) as my targets. In so far as possible I tried
to ensure that the major businesses of the targets and their controls were more
closely matched than possible with simple SIC codes. (2) Among the controls
within the same business sectors as the targets the publicly quoted ones were
selected. (3) The firms with the closest market capitalizations to my targets were
selected. (4) The final criteria used to select the ultimate control was that the firm
must not have been either taken-over or subject to a take-over attempt from 5
years prior to the LBO announcement to five years after.
133
ever, present four arguments in support of my decision to use
I, therefore, propose that reverse-LBO firms could be used as
rever-LBOs as proxies for post-buy-out success: Firstly,
proxies for superior performing buy-outs. Reverse-LBO firms
Investors would not be willing to invest in companies which
are not, however, the only LBO firms that experience success
have had a mediocre pre-secondary-IPO performance, even if
within a few years of going private. Some of the well perform-
the offer price is low [Shiller (1988)]. Although, I am not pro-
ing firms might also have been acquired by third party
posing that shareholders will be willing to overpay for their
investors. The problem with including acquisition-LBOs within
investments in successful firms, I do believe, however, that
such an analysis is that it is not possible to ascertain whether
shareholders are more reluctant to invest in poorly perform-
the acquisition was undertaken in order to take-over a com-
ing companies. Shareholders' apprehensions about trusting
petitor or a well-performing firm, or whether the LBO firm was
the insiders should also not be underestimated, especially
being rescued by a third-party organization or group (second-
when the insiders are also significant shareholders, as is the
ary-LBO). Since the subsequent performance of the acquired
situation in reverse-LBOs. Shareholders are aware of the fact
LBO firms is not available, I have decided to exclude them
that owner/managers will be attempting to manipulate the
from this study. The results obtained for the Reverse-
firm's accounts and/or over-state the reality, in order to artifi-
LBO/FAILED samples could, therefore, be deemed as proxies
cially increase reported performance and price [Myers &
for some of the better/worse performing targets and not all.
Majluf (1984)]. They, therefore, adjust their evaluations of the
target downwards in order to incorporate their distrust of the
Analyzing the longevity of these private structures, using the
management. Truly bad performing targets will, therefore, find
different methods by which the buy-in firms could exit, I find
it very difficult to persuade the outside shareholder to invest
that buy-ins tend to have substantially shorter lives as private
in their companies. Secondly, the pre-IPO-shareholders of the
firms, a median of 5.48 years, than MBOs (not shown here),
distressed buy-out firm will be reluctant to issue shares in
who were found to have median lives of 13 years. The implica-
order to retire some of the debt, because while it increases the
tion of this finding is that buy-outs are not as transitory an
value of company's debt their proportion of ownership
organizational form as Rappaport (1990) had postulated. The
decreases. This is analogous to the under-investment problem
shock-therapy hypothesis could not be used to explain finan-
associated with financial distress [Myers (1984)], in which
cial and governance structures maintained for 13 years10.
shareholders would be reluctant to invest any more capital to
Comparing the different methods of exit, I find that 60% of
rescue the company, when most of the gains are accrued to
buy-ins revert back into public ownership within 4 years of
the bondholders. Thirdly, previous investigations into the post-
going private, as compared to 6 years for buy-outs. These find-
LBO performance of REV-LBOs have found that they outper-
ings corroborate Jensen’s (1991) proposition that LBO-associ-
form their counterparts that retain their private status
ations anticipate reverting back into public ownership within 3
[Degeorge & Zeckhauser (1993), Muscarella & Vetsuypens
to 4 years of going private. The rate of exit via financial failure
(1990), Holthausen & Larcker (1996)]. Fourthly, I have moni-
is also found to be greater within MBIs than MBOs. This is most
tored the reports concerning these firms and ensured that
probably associated with the informational asymmetry which
none of the companies placed within the REV-LBO sample
the external bidders face.
experienced any type of financial distress between the time
they went private and when they reverted back into public
ownership.
134 - The
10 These results are quite different to those obtained by Kaplan (1991) or Wright et al.
(1995), who found the median number of years private to be 6.82 years and 7
years, respectively. The shorter median found by Kaplan could be, therefore,
attributed to the potential existence of MBIs within his data set. Wright et al
(1995), who segregate the two types of transactions also find that MBIs have
shorter private lives than MBOs. The firms within their sample, however,
experience shorter exit times than those of this paper. This could be attributed to
the fact that their analysis is primarily concentrated on divisional LBOs who are
expected to exit sooner than corporate buy-ins.
Factors influencing the method of exit
The overpayment hypothesis
The subsequent success or failure of the target should be
Jensen (1991) accused the large numbers of new and
highly dependant upon the degree to which the firm’s per-
inexperienced deal makers for the very large number of buy-
formance could be improved and consequently the company’s
out failures witnessed during the final years of the 1980's.
ability to meet its debt obligations. In this section all the fac-
These newcomers, who had been attracted by the yields made
tors which are deemed to influence the post-buy-in success,
on the earlier deals11, ignored the counter-cyclical nature of the
failure, and longevity of these private firms will be discussed.
earlier targets and selected many targets which they knew
would not justify the prices paid. The heavy competition
Underperformance criteria
among these deal-makers, who were effectively being paid for
Management buy-ins, analogous to tender offer acquisitions,
doing deals, bid the prices up and reduced the number of suit-
should be a mechanism by which managers who fail to maxi-
able deals. The result of such heavy competition between
mize their shareholders' wealth are replaced by those man-
deal-makers, who had very little to lose, was an overheated
agement teams who recognize the opportunity to reorganize
market in which bidders tended to overpay [Chiplin et al
and redeploy the firm's assets to create additional value
(1995); Kaplan & Stein (1993)].
[Jensen (1988)]. Based on this premise, firms that possess the
greatest restructuring potential, being those that are under-
My analysis of the median premium, MTB (POST) (calculated
performing their industrial peers, should make the most suit-
as the final value of the company’s shares multiplied by the
able targets. The proxies used to measure performance are:
number of shares outstanding, divided by the book value of
equity) and E/P (POST) ratios [calculated as the target’s earn-
■ Return on capital employed (ROTA) - Computed using the
ings per share on a fully diluted basis (COMPUSTAT #57),
operating income before depreciation (COMPUSTAT #13)
divided by the share price as of 1 day after the buy-in
divided by total assets (COMPUSTAT #6) [Kaplan (1989b)]
announcement], across different years, illustrates that the
and is used within this study as a gauge for current
potential for over-payment increased during the latter years
underperformance.
of the 1980’s. The median premium rose from a low of 24.22%
■ Market-to-book-value ratio (MTB) - Unlike the accounting
in 1980 to a high of 40.53% in 1987. The median premium paid
measures of profitability, which only depict current
within MBIs is also found to be significantly higher than that of
performance, the MTB ratio also considers the market's
MBOs (not shown here). The potential for financial failure is
expectation of future performance [Fama and French
exacerbated in circumstances where the over-payment is
(1992)]. The expectation is that companies which possess
financed with large volumes of high risk debt.
lower MTB Ratios are those that are underperforming their
industrial peers [Palepu (1986)]. THE MTB was computed by
The Market-to-Book Ratio [MTB (POST), representing MTB
dividing the market value of the firm’s equity - calculated by
after the announcement] might be judged by some as a crude
multiplying the share price of the target (COMPUSTAT #24)
gauge for over-payment. I am of the opinion, however, that
with the number of shares outstanding (COMPUSTAT #25),
since this ratio, market-adjusted, is compared between the
both at the end of the fiscal year immediately prior to the
three differing forms of post-buy-in structures it will have
announcement of the buy-in - by the book value of the
some explanatory powers. The Earnings to Price Ratio, E/P
firm's common equity (COMPUSTAT #60).
ratio, will also be used as a proxy for the market's perception
of the bid as of one day after the announcement. It will, therefore, be used to test the market's proficiency in appraising the
information available at the time of announcement.
11 Many of the initial capital providers demanded higher proportions of equity within
the bought-out firm and as a result reduced the levels of equity committed by the
deal-makers. In retaliation, many deal-makers started charging ‘front-end-loaded ‘
fees for closing the deals, which amounted to 2.7% of the purchase price of the
equity [Kaplan & Stein (1991)] and retained options on the success of the venture.
This arrangement reduced the risks undertaken by the deal-makers.
135
As the potential for over-payment has been found to be
bank debt financing dropped from a peak of 72.1% in 1981 to a
greater for those LBOs which occur during the latter years of
low of 45.6% in 1985. We should, therefore, expect buy-ins
the 1980’s, I have incorporated the year (YEAR) of the trans-
completed towards the latter years of the 1980’s to face
action as an independent variable. This proxy will allow us to
greater risks of failure.
investigate whether those buy-ins undertaken during the latter years of the 1980’s were more likely to fail, as well as con-
Free cash flows
trolling the regression for the year of the transaction.
The buy-in teams judge their ability to meet the interest payments by the level of free cash flows which the target gener-
Debt capacity hypothesis
ates. Although, possession of large free cash flows could also
High pre-buy-in debt capacities would have the benefit of mak-
be judged as a proxy for existence of high agency costs, the
ing it easier for the buy-in teams to both finance the transac-
buy-in teams would view it as a means for meeting the debt
tion, since they can use the target’s underlying assets as col-
payments. The magnitude of free cash flows has been calcu-
lateral, and to reduce the heavy debt burden accrued as a
lated as a percentage of the market value of common equity
result, by disposing some of the assets upon which the financ-
of the firm (EQ) as of the fiscal years immediately preceding
ing was procured. Suitable targets should, therefore, possess
the year of the buy-in (CF/EQ). This was done in order to
high pre-buy-in debt capacities. The two proxies used to rep-
remove the impact of large firms on the results [Lehn &
resent the pre-buy-in debt capacities are GEARING (PRE)
Poulsen (1989)].
[Calculated using the long-term debt (COMPUSTAT #9) divided by total assets (COMPUSTAT #6)] and FA(TANG)/ATA (PRE)
CF = INC - TAX - INTEXP - PFDDIV - COMDIV14
[obtained by dividing net fixed assets (COMPUSTAT #8) by
total assets (COMPUSTAT #6) less retained earnings (COMPU-
Target’s equity value
STAT #36)12].
Kaplan (1991) proposed that larger buy-outs are more likely to
revert back into public ownership because of the greater undi-
136
The likelihood of failure is expected to increase as the amount
versified risk of the equity owners and the firm’s needs for
of post-buy-out debt accrued increases. This situation is exac-
new investment financing. He did not, however, find any asso-
erbated when large proportions of this debt are of high risk
ciations between size and the firm’s reversion back into public
quality. Examination of the median percentage of bank debt
ownership. Wright et al (1995), who did find significant associ-
financing used and post-buy-in leverage proves that there was
ations between larger sized U.K. buy-outs and their rate of
an increase in leverage over time. This increase has been
exit, suggest, along with Kaplan, that smaller buy-outs need to
attributed by Jensen (1991) to the greater use of high risk
be included within such studies. Greater size also seems, how-
debt, typically in the form of Junk bonds or ‘cram down debts,’
ever, to increase the risk of failure. I also find that MBIs that fail
within the financing of these types of deals after 1985.
are significantly larger than those that revert-back into public
Looking at the median percentage of debt which has been
ownership or are acquired. Larger targets could be more
financed by the banks, the rest of which is in the form of sub-
prone to failure since they have greater volumes of debt which
ordinated high risk debt13, I find that as Jensen had proposed,
they need to pay off. Being larger, they are also more difficult
the proportion of bank debt financing decreased significantly
to restructure than their smaller counterparts. The result of
during the 1980’s, especially post-1985. The percentage of
which could also be greater risk of failure.
12 In this way we take away the impact of loss making firms by taking away (adding
back) the sum of retained earnings (Losses) from the total asset figure.
13 Unfortunately it was not possible to obtain information about the proportion of
debt which was made up of these differing types of subordinated debt. As it was
possible to ascertain the proportion of bank debt financing, I presented those
results. Readers can judge the outstanding proportion of debt to be less senior
and more risky.
14 INC - Operating income before depreciation (item # 13).
TAX - Total income taxes, (COMPUSTAT #16), minus change in deferred taxes from
the previous year to the current year (Change in COMPUSTAT item #35).
INTEXP - Gross interest expense on short- and long-term debt (COMPUSTAT item
#15). This is in the pre-buy-in state.
PFDDIV - Total amount of preferred dividend requirement on cumulative preferred
stock and dividends paid on non-cumulative preferred stock (COMPUSTAT item #19).
COMDIV - Total dollar amount of dividends declared on common stock
(COMPUSTAT item #21).
Comparing those that remain private with those that exit, I
deem the bid as unjustified, and would require the bidders to
find that the median number of years U.S.$100M-plus buy-in
pay a large premium to replace an already suitable manage-
firms remain private is three. This is starkly different to the
ment. As for targets that remain private, they were found to
10.36 years which it takes for the sub-U.S.$100M targets. The
significantly underperform their industrial rivals and possess
results illustrate, therefore, that the there is a strong relation-
high debt capacities and free cash flows. These are all suitable
ship between exit and size. This relationship, while strong for
characteristics for an MBI target.
those that revert back into public ownership or those that are
acquired, does not seem to hold for those that fail.
When comparing the characteristics of suitable targets with
those that remain private, I find that successful MBI targets
LBO-associations
significantly underperformed those that remained private and
These specialist partnership firms are expected to have a
possessed significantly lower fixed assets portfolios. The sig-
greater success rate in turning around their targets than their
nificantly lower fixed asset portfolios of the successful candi-
average first-timer bidding counterparts, mainly because of
dates could be associated with the fact that most of them
their accrued expertise within these types of transactions.
were lead by an LBO-Association, who do not seem to be high-
Associations between the involvement of these specialists and
ly reliant upon the underlying assets of the target for procur-
the likelihood of subsequent success within buy-in will be test-
ing the necessary financing15. The post-buy-in characteristics
ed below. This will be undertaken by the use of a dummy vari-
illustrate that suitable targets utilize significantly lower vol-
able which is allocated a value of 1 when the buy-in is lead by
umes of debt and that most of it is in the form of lower risk
an LBO-association and zero when they are not involved.
bank financing. They also possess significantly lower MTB
(POST) ratios, substantiating earlier claims that they might
Analysis of the targets' characteristics
have paid lower premiums for these targets than those paid
Looking at the market-adjusted mean values of the selected
for an average or failing targets. Failed buy-ins targets, on the
proxies, discussed above, for those buy-in targets that subse-
other hand, were found to significantly outperform those of
quently succeed (REV-LBO), Fail (FAILED), or remain private
the other categories. The targets' significantly better per-
(US-MBI-PRIV), respectively, I find that successful buy-in tar-
formance causes the buy-in teams to overpay. The fact that
gets significantly, at the 1% level, underperform their industri-
this overpayment is financed through the issuance of large
al counterparts, both currently and expected, and generate
volumes of high risk debt means that the likelihood of failure
large volumes of free cash flows. Suitable buy-in targets also
could be increased.
have significantly higher E/P ratios, demonstrating that the
buy-in teams might have paid lower premiums for them. Failed
The analysis demonstrates, therefore, that suitable buy-in tar-
buy-ins, on the other hand, significantly outperform, rather
gets are underperforming firms that were acquired by low vol-
than underperform, their industrial rivals. I stated above that
umes of low risk debt, while unsuitable targets were outper-
the major source of gains from these transactions is the miti-
forming firms that were over-priced and financed heavily with
gation of inefficient management. It is quite apparent, there-
high risk debt.
fore, that those that subsequently fail were not in need of res-
was significantly lower, at the 1% level, for this group, sug-
Tests of associations between subsequent
success or failure and the possession of certain
characteristics
gesting that perhaps the bidding team over-paid for their tar-
In table 1, I have multinomially regressed the likelihood of sub-
gets. This would be quite logical, since the markets would
sequent success or failure of the target with the possession of
cue. In fact if any company needed to be rescued, it would
have been the control firm used. I also found that the E/P ratio
15 The LBO-Associations are able to utilize their long-term track- and success-records
within these types of transactions as collateral to procure the necessary financing.
Their long-term association with the financiers of these transactions also helps
them in such endeavors.
137
certain pre-buy-in characteristics. Within the analysis, the
illustrates that bidders, especially LBO-associations, who use
dependant variable has been allocated a value of 0, if the firm
low volumes of low risk debt and can pay lower premiums for
remains private, 1, if the firm reverts back into public owner-
their targets will subsequently succeed. Those bidders that
ship, and 2, if the firm subsequently fails. The results illustrate
over-pay with large volumes of high risk debt will in all proba-
that the target's subsequent success is directly associated
bility fail. The high success rate of those targets that use bank
with the following pre-buy-in characteristics:
financing could be associated with the banks’ better credit
analysis.
■ Low pre-buy-in leverage, which simplifies the financing
process.
MBI
REVERSE-LBO
FAILED
-23.376
10.585
(-2.26)a
(0.72)
■ Current and expected underperformance of the target.
■ Involvement of LBO-associations.
CONSTANT
■ High E/P ratio, which could be judged as a proxy for lower
premiums.
GEARING (PRE)
■ The size of the target.
■ The year of the buy-in.
Larger sized targets bought-into during the latter years of the
CF/EQ (PRE)
FA(TANG)/ATA (PRE)
1980’s were more likely to have reverted back into public ownership within 7 years of going private16. There is, therefore, a
ROTA (PRE)
significant relationship between size and longevity. This could
be associated with the involvement of the LBO-associations
MTB (PRE)
who require their targets to revert back into public ownership
within a few years of going private. While this relationship
LBO - ASSOCIATION
might not have been significant for buy-outs, in which the
LBO-associations are not involved within the management of
EQUITY
the target, it has been found to be for buy-ins. This finding,
once again, corroborates Jensen’s (1991) proposition that
YEAR
LBO-associations’ involvement reduces the longevity of LBOs
-0.010
0.017
(-1.53)
(0.83)
0.014
-0.001
(1.01)
(-0.12)
0.013
-0.006
(1.43)
(-0.34)
-0.089
0.048
(-2.47)a
(1.51)
-0.005
0.011
(-2.13)a
(2.93)a
1.607
-0.001
(2.44)a
(0.22)
0.004
-0.001
(3.24)a
(-0.44)
0.222
-0.157
( 1.90)b
(-0.90)
and contradicts the findings of Kaplan (1991).
CHI-SQ
The likelihood of subsequent failure increases when the target
MAX LIKELIHOOD RATIO INDEX
is outperforming its peers and over-priced. While the involve-
PREDICTION SUCCESS
114.910
0.509
83.22%
ment of LBO-associations significantly increases the likelihood
of success, their exclusion from the deal does not seem to
a
increase the likelihood of failure. The size of the target and the
b
Statistically Significant at 5% Confidence Level
year of the transaction do not seem to have been influential in
c
causing the target to fail.
Table 1 - Multinomial logistic regression of the likelihood of failure or success based upon
the target's pre-buy-in characteristics (t-Statistics within parenthesis).
Table 2, which investigates associations between the targets'
post-buy-in characteristics and their subsequent prosperity,
138
16 Seven years was selected as the number of years before which the firm must have
exited. This is one year more than the median, but it encapsulates most of the exit
transactions.
Test of market's foresight
MBI
REVERSE-LBO
FAILED
Table 3 reports the cumulative abnormal returns (CARs) for
20.000
-75.882
public ownership, face financial distress, and retain their pri-
a
( 2.27)
a
(-2.47)
vate status, along with a comparison of the CARs between the
-43.578
94.277
members of the two former groups and the latter15. Columns
(-3.33)
a
(2.60)
(1) to (3), demonstrate that the announcements of these trans-
21.477
-22.357
actions are associated with significant gains for the target
a
a
buy-in announcements of those targets that revert back into
CONSTANT
GEARING (POST)
a
BANK DEBT PROPN. (POST)
MTB (POST)
(3.31)
(-2.95)
shareholders, whether the targets subsequently succeed or
-0.005
0.012
not. Columns (4) and (5) compare the CARs of REV-LBOs and
(-2.15)a
(2.87)a
FAILED MBIs with those that remain private, respectively. We
1.903
-0.004
can observe that the markets react significantly more posi-
(-0.54)
tively to announcements of those buy-ins deemed suitable
LBO - ASSOCIATION
a
(2.55)
than those that are not. The CARs of REV-LBOs are signifiCHI-SQ
149.67
cantly higher than those of private buy-ins, while FAILED Buy-
MAX LIKELIHOOD RATIO INDEX
0.663
ins are significantly lower.
PREDICTION SUCCESS
90.21%
a
b
c
Table 2 - Multinomial logistic regression of the likelihood of failure or success based upon
the target's post-buy-in characteristics (t-Statistics within parenthesis).
MBI
REV-LBO
FAILED
US-MBI-PRIV
REV-LBO LESS
FAILED LESS
US-MBI-PRIV
US-MBI-PRIV
(1) - (3)
(2) - (3)
(1)
(2)
(3)
(4)
(5)
20-DAY
44.33a
22.40a
32.56a
11.77a
-10.16a
10-DAY
37.42a
18.18a
28.58a
8.84a
-10.40a
0.89
- 2.74b
1-DAY
a
a
22.47
a
18.84
a
21.58
b
c
Table 3 - Cumulative abnormal return calculations for 20-, 10-, and 1-day windows
17 Please Note: I used a non-parametric methodology was used to calculate the CARs
[Corrado (1989)]. The Specification, Goldfield-Quant and Szroeter’s, tests
conducted to assess the homoscedasticity of the residuals could not reject the
hypothesis that the residuals are homoscedastic and normally distributed at the
5%. This is true for all the share price analysis undertaken.
139
Summary and conclusion
the stock market ‘short-termism’ [Charkham (1994)].
The results of this study demonstrate that suitable MBI targets
Nevertheless, these same investors that provide no loyalty to
do possess distinguishing characteristics and that the stock
capable incumbents expect full loyalty in return.
markets are capable of predicting subsequent successes or
failures of targets within 24 hours of the announcement of
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significantly underperforming their industrial peers, currently
and expected, while unsuitable targets, those that declared
bankruptcy, were not. A significantly direct relationship was
also found between over-payment and the likelihood of subsequent collapse, results corroborating with those of Kaplan &
Stein (1993). The involvement of the LBO-associations within
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track records in turning around such underperforming targets.
However, the questions that remain unanswered are:
■ If the markets are able to predict the unsuitability of a
target, why are the bidders unable to?
■ If the markets deem a target unsuitable, why are they
allowing them to be acquired?
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potential in improving the performance of the target and
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other market participants. We expect that the Winners Curse
Hypothesis is also highly valid in the case of failed MBIs, supported by our finding that the MBIs that subsequently failed
were typically over-priced. In response to the second question,
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[Jenkinson & Mayer (1994), Franks & Mayer (1996)]. Markets
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140 - The
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• Mueller, D.C., 1969, ‘A Theory of Conglomerate Mergers,’ Quarterly Journal of
• Muscarella, C.J., and M. R. Vetsuypens., 1990, ‘Efficiency and Organizational
Structure: A Study of Reverse LBOs,’ Journal of Finance, 5, 1389-1413
• Myers, S.C., 1984, ‘The Capital Structure Puzzle,’ Journal of Finance, 39, 575-592
• Myers, S.C., and N.S.Majluf., 1984, ‘Corporate Financing and Investment Decisions
when Firms Have Information That Investors Do Not Have,’ Journal of Financial
• Opler, T.C., 1993, ‘Controlling Financial Distress Costs in Leveraged Buyouts With
Financial Innovation,’ Financial Management, 22, 37-41
• Opler, T.C., and Titman, S (1993), 'The Determinants of Leveraged Buy-out Activity:
Free Cash Flow vs. Financial Distress Costs', Journal of Finance, XLVIII(5), 1985-1999.
• Palepu, K.G., 1983, ‘The Determinants of Acquisition Likelihood,’ Unpublished
Manuscript (Harvard University, Boston, MA)
• Palepu, K.G., 1986, ‘Predicting Takeover Targets: A Methodological and Empirical
Analysis,’ Journal of Accounting and Economics, 8, 3-35
• Perry, S,E., and T.H.Williams., 1994, ‘Earnings Management Preceding Management
Buyout Offers,’ Journal of Accounting and Economics, 18, 157-179
• Roll, R., 1986, ‘The Hubris Hypothesis of Corporate Takeovers,’ Journal of Business,
59, 197-216
• Schipper, K., and A. J. Smith, 1991, ‘Effects of Management Buy-outs on Corporate
Interest and Depreciation Tax Deductions,’ Journal of Law and Economics,
34, 295-341
• Shiller, R. J., 1988, ‘Initial Public Offerings: Investor Behavior and Underpricing,’
Working paper, National Bureau of Economic Research.
• Weston, J.F., K.S.Chung., and S.E.Hoag., 1990, ‘Mergers, Restructuring, and Corporate
Control,’ Prentice-Hall International Publishing, Ch 8, 192-195.
• Wright, M, Wilson, N, Robbie, K and Ennew, C (1995), 'An Analysis of Management
Buy-out Failure', Managerial and Decision Economics, 16.
141
Guidelines for manuscript submissions
Guidelines for authors
Manuscript guidelines
In order to aid our readership, we have established some guidelines to
ensure that published papers meet the highest standards of thought
leadership and practicality. The articles should, therefore, meet the
following criteria:
All manuscript submissions must be in English.
1. Does this article make a significant contribution to this field of
research?
2. Can the ideas presented in the article be applied to current business
models? If not, is there a road map on how to get there.
3. Can your assertions be supported by empirical data?
4. Is my article purely abstract? If so, does it picture a world that can
exist in the future?
5. Can your propositions be backed by a source of authority, preferably
yours?
6. Would senior executives find this paper interesting?
Subjects of interest
All articles must be relevant and interesting to senior executives of the
leading financial services organizations. They should assist in strategy
formulations. The topics that are of interest to our readership include:
•
•
•
•
•
•
•
•
•
•
•
142 - The
Impact of e-finance on financial markets & institutions
Marketing & branding
Organizational behavior & structure
Competitive landscape
Operational & strategic issues
Capital acquisition & allocation
Structural readjustment
Innovation & new sources of liquidity
Leadership
Financial regulations
Financial technology
Manuscripts should not be longer than 5000 words each. The maximum
number of A4 pages allowed is 10, including all footnotes, references,
charts and tables.
All manuscripts should be submitted by e-mail directly to the
[email protected] in the PC version of Microsoft Word. They should all
use Times New Roman font, and font size 10.
Where tables or graphs are used in the manuscript, the respective data
should also be provided within a Microsoft excel spreadsheet format.
The first page must provide the full name(s), title(s), organizational affiliation of the author(s), and contact details of the author(s). Contact details
should include address, phone number, fax number, and e-mail address.
Footnotes should be double-spaced and be kept to a minimum. They
should be numbered consecutively throughout the text with superscript
Arabic numerals.
For monographs
Jensen, M., Corporate Control and the Politics of Finance. Journal of
Applied Corporate Finance (1991), pp. 13-33.
For books
Copeland, T., T. Koller, and J. Murrin. Valuation: Measuring and Managing
the Value of Companies. John Wiley & Sons, New York, New York (1994).
For contributions to collective works
Ritter, J. R., 1997, Initial Public Offerings, in Logue, D. and J. Seward, eds.,
Warren Gorham & Lamont Handbook of Modern Finance, South-Western
College Publishing, Ohio.
Manuscript submissions should be sent to
Shahin Shojai, Ph.D.
The Editor
[email protected]
For periodicals
Griffiths, W., Judge, G., 1992, ‘Testing and estimating location vectors
when the error covariance matrix is unknown’, Journal of Econometrics
54, 121-138.
Capco
Clements House
14-18 Gresham Street
London EC2V 7JE
Tel: +44-20-7367 13 21
Fax: +44-20-7367 1001
For unpublished material
Gillan, S., and L. Starks. Relationship Investing and Shareholder Activism
by Institutional Investors. Working Paper, University of Texas (1995).
Request for papers — Deadline June 25th, 2004
The world of finance has undergone tremendous change in recent years.
Physical barriers have come down and organizations are finding it harder
to maintain competitive advantage within today’s truly global market
place. This paradigm shift has forced managers to identify new ways to
manage their operations and finances. The managers of tomorrow will,
therefore, need completely different skill sets to succeed.
It is in response to this growing need that Capco is pleased to announce
the launch of the ‘journal of financial transformation.’ A journal dedicated
to the advancement of leading thinking in the field of applied finance.
The journal, which provides a unique linkage between scholarly
research and business experience, aims to be the main source of
thought leadership in this discipline for senior executives, management
consultants, academics, researchers, and students. This objective can
only be achieved through relentless pursuit of scholarly integrity and
advancement. It is for this reason that we have invited some of the
world’s most renowned experts from academia and business to join our
editorial board. It is their responsibility to ensure that we succeed in
establishing a truly independent forum for leading thinking in this new
discipline.
You can also contribute to the advancement of this field by submitting
your thought leadership to the journal.
We hope that you will join us on our journey of discovery and help shape
the future of finance.
Shahin Shojai
[email protected]
For more info, see page 142
© 2004 The Capital Markets Company. VU: Shahin Shojai,
Prins Boudewijnlaan 43, B-2650 Antwerp
All rights reserved. All product names, company names and registered trademarks in
this document remain the property of their respective owners.
143
Design, production, and coordination: Cypres — Marcel Duhamel and Pieter Vereertbrugghen
© 2004 The Capital Markets Company, N.V.
All rights reserved. This journal may not be duplicated in any way without the express
written consent of the publisher except in the form of brief excerpts or quotations for review
purposes. Making copies of this journal or any portion there of for any purpose other than your
own is a violation of copyright law.
Four Key
Questions
for
Wealth
Managers
1
2
3
4
Rising costs, heavier
regulation, tougher clients
in a tougher market –
how can a Private
Banking business cope?
Can we respond quickly
enough to all these
changes?
SEI knows about the competitive
benefits of outsourcing in private
banking institutions.
Should we be redefining
our private client value
proposition?
To get a copy of SEI’s special report
‘Outsourcing and the European
Wealth Management Market’*, call
Francis Jackson on + 44 (0)207 297
6308, or Email [email protected]
How do we decide
what is best done in
house, and what needs
to be outsourced?
Hear what the industry is saying.
* Research amongst CEOs, CFOs and
Senior Executives of wealth management
institutions in 10 European Countries
SEI Investments (Europe) Ltd,
4th Floor, The Economist Building,
25 St James’s Street, London SW1A 1HA
is regulated and authorised by the
Financial Services Authority
SEI.
New Ways. New Answers.
www.capco.com
Antwerp T +32 3 740 10 00
Bangalore
T +91 80 527 0353
Boston T +1 617 262 1135
Frankfurt T +49 69 9760 9000
London T +44 20 7367 1000
New York T +1 212 284 8600
Paris T +33 1 47 55 30 90
San Francisco T +1 415 445 0968
Singapore T +65 6395 6998

Alternative investments

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