SEC Hedge Fund Guidelines Contain Some Useful Advice

The SEC has had a somewhat limited role in regulating hedge funds, though certain hedge funds will have to register with the SEC beginning February 2006. Nevertheless, the SEC has successfully exposed and prosecuted hedge funds in cases of fraud.

A short discussion about investing in the hedge funds or hedge fund of funds on its website here. While we don't disagree with any othe points mentioned, we would highlight getting to know the service providers and brokerage firms of a hedge fund (including accountants, brokerage and clearing firms and administrator) and get (and verify) the latest audited performance statements. Several alleged frauds exposed by the SEC in the last year either didn't have an independent accounting firm or couldn't provide audited statements. Some funds produced false account statements or forged clearing firm statements. In several cases, the funds traded through a related brokerage firm.

The SEC list includes:

• Read a fund's prospectus or offering memorandum and related materials.
• Understand how a fund's assets are valued.
• Ask questions about fees. Fees impact your return on investment.
• Understand any limitations on your right to redeem your shares.
• Research the backgrounds of hedge fund managers.
• Don't be afraid to ask questions.

Hedge Fund Strategy Classification: My Perspective

A common topic of discussion in hedge fund circles is how strategies are related and should be grouped or classified. Putting strategies into broader groupings may be useful to the risk management effort. Of course, one can argue about how coarse or fine the strategies should be.

On one hand, one could argue all manager's strategies are unique (thus making any classification meaningless) or one could group it in only two or three categories. In the Handbook of Alternative Investments, Mark Anson classifies strategies into three groups: strategies taking market risk, strategies taking credit risk, and those taking low market and credit risk.

Under market risk focused, Anson lists Equity long/short, short selling and Global Macro. Under Credit Risk, he lists convertible arbitrage, event driven, merger arbitrage, fixed income, and relative value. Under low market and credit risk, he lists market neutral and market timing.

We had occassion to independently classify twenty-two strategy indices into meaningful categories and we came up with six (including managed futures). Since managed futures is technically not a hedge fund strategy, it is not part of Anson's hedge fund classification scheme. Our classification used a factor analysis that we performed on approximately 10 years of data for two providers: CSFB/Tremont and Evaluation Associates.

Our Market Neutral category has only one index, the Evaluation Associates Market Neutral index.

Our Equity category includes Equity Long/Short (except for Emerging Markets and Equity Global) and Short Sellers. It excludes Global Macro.

Our Global classification includes Equity Global, Emerging Markets, and Evaluation Associates Discretionary.

Our Relative Value category includes Convertible and Fixed Income Arbitrage and Relative Value Multi-Strategy.

Our Event Driven category includes Merger Arbitrage and Distressed, as well as Emerging Markets, and Event Driven Multi-Strategy.

Relative Value and Event Driven shold not be lumped together, as they have very different correlation to the second factor.

Our Managed Futures category has Managed Futures and Systematic indices

Finally, two indices did not fit well in our clasification scheme: CSFB Tremont Global Macro and the CSFB/Tremont Equity Market Neutral index. Both have too much exposure to the first directional factor.

In summary, our chief disagreements with the Anson classification scheme are the placement of Global Macro in the market risk category and the failure to distinguish between relative value and event driven strategies.

But What is Hedge Fund Alpha Anyway?

We've thrown around the word alpha the last few posts as if everyone knew what it is. It does have a common Capital Asset Pricing Model (CAPM) definition, typically applied to stocks. But we think the same analysis is quite inadequate for hedge funds.

Moneychimp.com offers this definition for alpha:

Measure of a stock's performance beyond what its beta would predict

So, we now need a definition of beta:

A measure of an investment's volatility, relative to an appropriate asset class. For stocks, the asset class is usually taken to be the S&P 500 index

So, an equity's return can be broken down into a market-related component (multiplied by a factor which takes into consideration a stock's riskiness or uncertainty) and an unexplained factor, the alpha.

Now, if the world really operated with only one factor, "the market", this might be a usueful analysis. It has applications in evaluating mutual funds: you can measure a manager's performance by looking at his beta exposure to the market to see if the resulting alpha is positive or negative.

Unfortunately, in a hedge fund world, managers are exposed to more than a single factor. It is quite easy to look at returns relative to credit spreads and volatility and see that managers may, depending on the strategy, make bets on the direction of these factors as well as market direction.

So reliance on a one factor model for hedge funds is likely to be misleading. If some of the other major influences are included, a beter idea of which strategies are producing alphas can be derived.

We'll provide more discussion of hedge fund alpha in a later post. But, for now, we would suggest that gap between the best and worst alpha strategies may be as large as 7-8% a year, a substantial spread.

Further Thoughts: Alpha and Return Expectations

We titled our last post "Is the Hedge Fund Game Over?" and left you for a few days: we hope readers did not think we left this venture and forgot to turn off the lights. But we have reflected on one paragraph in that post:

William Sharpe contends:

"On average, the clients are going to get less than Treasury bills."

On some level, we agree: alpha is a limited commodity and the more funds there are pursuing the same or similar niches, the less opportunity there is for good returns.

We can be accused fairly of "intellectual hydroplaning" with those comments.

In short, William Sharpe's contention that clients will get less than Treasury bills may be accurate in the short run. However, an expected return below Treasury bills (net of fees) is not a viable long term return objective. Very simply, assets will leave the hedge fund industry in droves (perhaps as fast as they came) if this were to be the case.

The result we expect will be an expected return above Treasury bills for hedge funds. Nevertheless, we do not mean to question the impact of increased assets on returns. We believe alpha exists for a variety of structural reasons and that it is reasonably finite (or grows marginally as the underlying asset classes grow).

For example, investing in illiquid securities like distressed probably has a positive expected returns because there are debt holders that cannot or do not want to carry sub-investment grade debt on their books. The amount of distressed debt obviously is a function of the business and credit cycle. The returns are a function of that supply and the amount of funds chasing that supply.

Is the Hedge Fund Game Over? Are We Chasing After T-Bill Returns?

Bloomberg has writen a News Feature on Hedge Funds and has enough commentary and quotes from industry professionals for several posts. The article starts off by saying

:"...the hedge fund industry entered the final months of 2005 with almost no hope of reliving its past glories, at least for now."

Returns this year for many strategies are below what they were in 1999 (the past glory?) and generating "standout profits" (whatever those are) will be more difficult due to competition and megafirms like D.E. Shaw and Bridgewater Associates.

William Sharpe contends:

"On average, the clients are going to get less than Treasury bills."

On some level, we agree: alpha is a limited commodity and the more funds there are pursuing the same or similar niches, the less opportunity there is for good returns.

But this is a rather simplistic, broad brush appraisal and deserves some further thought and research. We'll bring it to you over the next week.

Link: D.E. Shaw, Bridgewater Top List of World's Biggest Hedge Funds

Distressed: United Airlines Bankruptcy Terms Announced

One of the things I look for is real-life examples of alternative investments, which allow students to put sometimes unfamiliar concepts in some context. Distressed secuities investing has been a very good area over the last few years, partially as a result of the credit cycle and partially as a result of supply.

The United Airlines bankruptcy is one I have personally followed because I was short a small amount of common stock. So I'm keenly aware that the process has taken three years. Finally, a reorganization plan is on the table and February 2006 is the tentative date. The terms of the deal are contained in this Rocky Mountain News article.

Basically, the senior debt holders have been paid off in full and the unsecured junior debt holders are looking at 4-8 cents return on approximately $30 billion in outstanding debt. The payment will be in the form of new equity.

Several creditors faced with getting back five cents on the dollar indicate they are unhappy, but:

"If, in fact, unsecured creditors are getting what's left over after the senior creditors are paid in full, they can't say they're not getting paid enough because that's all that is left," said Douglas Baird, a University of Chicago law professor.

Since assets are not sufficient to pay off the junior debt holders, it follows that the old equity is worthless and the article makes this clear:

Stockholders will get completely wiped out and won't be able to vote on the plan.

But of course, the old common shares are still trading for 62.5 cents as of November 28. Even though the company advised in June 2003:

"...the company believes that its equity securities have little or no value and it is highly likely that the equity in UAL will be canceled under any plan of reorganization proposed by the company."

So much for efficient markets.

David Swenson: Questions Value of the Hedge Fund of Funds

Yale University's David Swensen topped the list of endowment returns in the latest fiscal year that ended in June, according to Bloomberg survey of 25 largest endowments.

It was no one-year anomaly either. Swensen produced an average annual return of 17.4 percent during the past decade. How did he do it? With significant allocations to alternative assets, including hedge funds, real assets (including real estate timber and energy), and private equity. It is not coincidental that the was also one of the first endowments to invest in real estate and hedge funds early, both alternative investment categories.

Swenson is not an enthusiastic support of mutual funds or hedge fund of funds, suggesting that the fee structures of these vehicles make it difficult to add value over the unmanaged alternatives that have become available.

In the hedge fund arena, the addition of a typical 1% management fee and 10% incentive fee (on top of the underlying funds' fees) does make it difficult for a fund of funds to outperform. However, fund of funds often claim their value comes from:

Access to funds otherwise closed to investors. We would amend this as access to superior management (whether closed or open.) If the "closed managers" underperform their strategy, most investors won't care that they're invested with closed managers.

Ability to optimally allocate to strategies and shift assets to outperforming strategies. This is the tactical asset allocation argument, applied to hedge funds. Several funds have alluded to this possibility.

Ability to leverage the hedge fund portfolio somewhat for extra return. Financing may be more available to a fund than an individual. If the fund of fund has done a good job in contructing the portfolio, some leverage at the fund of fund level may be reasonable.

Are hedge fund of funds able to use these techniques to overcome their management and incentive fees. As a group, probably not. But these are the questions an investor must ask if considering a hedge fund of fund.