HEDGE FUNDS AN INSTRUCTIONAL LOOK

Transcription

1 HEDGE FUNDS AN INSTRUCTIONAL LOOK HEDGE FUND STRATEGIES

2 PREFACE TODAY, HEDGE FUNDS OFTEN ACCOUNT FOR THE LARGEST SHARE OF INSTITUTIONS ALLOCATION TO ALTERNATIVE INVESTMENT STRATEGIES WHICH THEMSELVES FREQUENTLY MAKE UP THE LARGEST SINGLE ALLOCATION IN INSTITUTIONAL PORTFOLIOS. THUS, IT RISKS UNDER- STATEMENT TO SAY THAT HEDGE FUND STRATEGIES ARE PLAYING A KEY ROLE IN DETERMINING LONG-TERM INVESTMENT OUTCOMES. YET, HEDGE FUND STRATEGIES CAN BE DIFFICULT TO UNDERSTAND. OVER TIME, AS THEIR EXPERIENCE WITH HEDGE FUNDS HAS DEEPENED, STAFF AND INVESTMENT COMMITTEE MEMBERS HAVE BECOME INCREASINGLY KNOWLEDGEABLE AND CONVERSANT IN THE LANGUAGE OF HEDGE FUND MANAGEMENT. NEWER TRUSTEES AND THOSE WITHOUT A BACKGROUND IN FINANCE AND INVESTMENTS, HOWEVER, MAY NOT POSSESS THE SAME LEVEL OF EXPERTISE. BUT THE SIZE OF TODAY S ALLOCATIONS TO HEDGE FUNDS MAKES IT ESSENTIAL FOR ALL POLICY MAKERS TO HAVE A BASIC GRASP OF HEDGE FUND FUNDAMENTALS AND THE ROLE THAT HEDGE FUNDS PLAY IN LONG- TERM PORTFOLIOS. IT IS FOR THIS REASON THAT COMMONFUND IS PUBLISHING THIS BROCHURE. WE HOPE IT IS A USEFUL GROUNDING IN THIS SUBJECT, AND THAT IT WILL CONTINUE TO SERVE AS A GUIDE FOR FUTURE REFERENCE. See Important Notes on the back cover.

3 TABLE OF CONTENTS 2 HEDGE FUNDS DEFINED 4 COMMON CHARACTERISTICS OF HEDGE FUNDS 6 THE ROLE OF HEDGE FUNDS IN LONG-TERM INVESTMENT POOLS 10 HEDGE FUND STRATEGIES IN DETAIL 12 THE CURRENT STATE OF THE HEDGE FUND MARKET 14 EVALUATING, CHOOSING AND MONITORING HEDGE FUND MANAGERS 18 IMPLEMENTATION: BUY OR BUILD? 20 CONCLUSIONS 21 GLOSSARY OF TERMS 1

4 HEDGE FUNDS DEFINED THE TERM HEDGE FUND REFERS TO A WIDE RANGE OF ALTERNATIVE INVESTMENT STRATEGIES. TAKEN LITERALLY, IT DESCRIBES AN INVESTMENT PRACTICE THAT GOES BEYOND TRADITIONAL LONG-ONLY INVESTING THE BUYING AND SELLING OF STOCKS AND BONDS IN THE CASH MARKET TO ENCOMPASS THE USE OF TRADING TECHNIQUES DESIGNED TO HEDGE OR PROTECT THE INVESTOR AGAINST RISKS TO THE PORTFOLIO. EXAMPLES OF SUCH TECHNIQUES INCLUDE ENGAGING IN SHORT SELLING OF SECURITIES TO PROTECT AGAINST PRICE DECLINES, PURCHASING AND SELLING PUT AND CALL OPTIONS TO LIMIT MARKET LOSSES, AND ENTERING INTO FUTURES, SWAPS OR OTHER DERIVATIVE CONTRACTS TO LIMIT VOLATILITY AND CURB LOSSES. MANY HEDGE FUNDS CONFORM TO THIS CLASSIC DEFINITION. SUCH FUNDS TYPICALLY PROVIDE A RETURN THAT TRAILS LONG-ONLY BENCHMARKS IN RISING MARKETS, BUT LOSES LESS RELATIVE TO THOSE BENCHMARKS IN DECLINING MARKETS. OVER MULTIPLE MARKET CYCLES, THE INTENDED (BUT NOT ASSURED) RESULT IS THAT THE COMPOUNDING OF THESE RETURNS PARTICULARLY THE DOWNSIDE PROTECTION SHOULD PRODUCE HIGHER INVESTMENT RESULTS THAN TRADITIONAL LONG-ONLY INVESTING. 2

5 Other types of hedge funds are less concerned with these protective approaches and employ a wider variety of methodologies, sometimes combined with leverage, with the goal of delivering excess return (or alpha) in addition to the overall market return (or beta) to investors. These funds seek to be compensated for the specific risks that they undertake in pursuit of this excess return. As a result, their returns may be higher, and the volatility and risk associated with those returns may be higher as well. All of these strategies are referred to generically as hedge funds. Some market participants use the term marketable alternative strategies to describe the sector: marketable because managers of these strategies invest in instruments that are generally bought and sold on exchanges rather than being traded privately; and alternative because they employ investment practices and instruments that go beyond traditional long-only investing. A BRIEF OVERVIEW OF HEDGE FUNDS The first hedge funds were, indeed, designed to hedge. At least two centuries ago, millers and grain merchants on the agricultural commodity exchanges of Europe took long and short positions in different but related agricultural markets to protect themselves from sudden adverse moves in the prices of wheat, oats and other grains in which they dealt. Over time, these principles began to be applied to trading in equities, bonds, currencies and other financial instruments. The creation of the first modern hedge fund is often attributed to Alfred Winslow Jones, a former Fortune magazine writer. To reduce the effect of stock market fluctuations on his fund s valuation, he both bought stocks and sold stocks short. He also employed leverage, borrowing money to invest in the portfolio and thereby increasing his long exposure. Because mutual funds were largely constrained to long-only investing under U.S. securities laws, Jones structured his fund as a private limited partnership and offered it to investors under private placement restrictions thus enabling him to avoid registering his firm or his fund with the Securities and Exchange Commission (SEC). Under the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in July 2010, most hedge fund managers are required to register their firms with the SEC, but the investment funds themselves are still offered privately and are, as a result, exempt from registration a fact which limits the number and type of investors that can participate in hedge funds. We will discuss the workings of the major types of hedge fund strategies in detail later in this publication. At the outset, however, it can be said that while the variety of these strategies is limited only by the ingenuity of the investment professionals who devise them, they can be categorized into two broad groups: > > Relative value strategies are intended to be market-neutral that is, the manager does not take a position on the direction of the broad market. Rather, returns derive primarily from the ability of the manager to profit from taking a view on the outcome of certain events (for example, the successful completion of a proposed merger of two companies) or from arbitrage (exploiting a price discrepancy between similar securities or sectors). Returns thus come primarily from alpha earned by the manager rather than from beta or market risk. These strategies are often identified as absolute return or marketneutral strategies. > > Directional strategies, on the other hand, describe situations where the manager does take a position on the direction of equity markets, interest rates, currencies or commodities. These strategies, also called flexible beta strategies, are designed to generate pure alpha by hedging and/or leveraging the primary beta or market risk (for example, stock market or interest rate risk) that drives returns in the underlying asset class. Directional strategies tend to be more volatile and can offer the potential for higher returns than relative value strategies. 3

6 COMMON CHARACTERISTICS OF HEDGE FUNDS Apart from the different sources of return, hedge funds share a number of common characteristics: Relative illiquidity Hedge funds are typically structured as limited partnerships and sold to investors under private placement exemptions from the registration requirements of the securities laws. As a result, investors are not able to buy and sell their interests in a given fund on an exchange, and the typical way of exiting a fund investment is by redeeming it selling it back to the manager. Managers are understandably concerned about protecting themselves and their fund investors from a series of large redemptions that might require the manager to liquidate or unwind investment positions at a disadvantageous time. Thus, while investment positions in a given hedge fund might be in securities that are, in themselves, quite liquid, the hedge funds themselves, through their liquidity terms, often restrict transferability and limit redemptions. Minimum holding periods, called lock-up periods during which investors cannot redeem their investment, or in some cases, can only redeem upon payment of a steep redemption fee can range from one year to as long as five years. Moreover, even after the lock-up period has expired, the required notice period for redemption can be as long as six months, with a payout period of an additional 30 to 90 days before the investor receives any proceeds. Provisions specifying a single annual redemption opportunity, with a minimum 120-day notice period, are not uncommon. In addition, in order to prevent an untimely run on the fund, many investment agreements also provide for a gate in the event that more than a defined percentage of investor assets wants to exit the fund at the same time; in this case, the payout of the investors capital can be further delayed to allow for an orderly unwinding of the investment positions in the fund. Unconstrained and expanded tool sets As we have seen, hedge fund managers seek to exploit risk and return opportunities using a broad range of tools and techniques. Fund subscription documents, while they summarize the investment strategy that the manager intends to pursue, usually also permit the manager a high degree of freedom to use other strategies and techniques to seek returns on a relatively unconstrained basis. This latitude gives the manager the ability to vary the fund s net exposure to markets overall as it attempts to profit in a wide variety of market conditions. The unconstrained nature of these mandates, however, means that investors money may be deployed in different ways than was indicated in the manager s initial strategy description. As the following section explains, the benefit of flexibility is thus counterbalanced by a lack of certainty or transparency as to the specific strategies and techniques that may be employed. Less transparency Because of the proprietary nature of many hedge fund strategies and the illiquidity of many of the underlying investments, investors are often given little, if any, real-time information as to how or in what securities the fund is actually invested. Some techniques commonly used by hedge fund managers, such as leverage, short selling and derivatives, are not compatible with the daily valuation practices and liquidity requirements of traditional long-only investment managers. Moreover, in the unconstrained investment environment described in the preceding section, freed from the requirement to provide investment position transparency, the manager may pursue other strategies without promptly informing investors, making it very difficult to monitor the manager and understand the true risks inherent in the fund s investments. The frequency and content of hedge fund managers reports also differ from those of conventional investment managers. As is often the case in limited partnership investment arrangements (including real estate and private capital), hedge fund managers report to their investors less frequently than do managers of traditional, more-liquid strategies. And, while summary monthly return reports are not uncommon, most hedge fund managers devote their attention to quarterly and annual reporting. 4

7 Monitoring and valuation, too, pose a challenge. Well-resourced investors monitor their hedge fund managers using quantitative risk parameters to augment periodic position reporting. But investors in the more fast-moving strategies that involve a high volume of trading must generally satisfy themselves with after-the-fact and pointin-time static assessments. And if a fund holds illiquid positions, precise valuations may be impossible. High management fees and transaction costs In contrast with long-only managers that typically charge a flat fee based on a percentage of the market value of the assets under management, hedge fund managers generally share directly in any gains that may result from the strategy. A typical hedge fund fee includes both an annual management fee of 2 percent of net assets and a performance fee of 20 percent of the fund s annual gain, a compensation method often described as 2 and 20. Less common is a hurdle rate, usually computed as a proxy for a basic expected return on capital, which must be achieved before any performance fees can be earned by the manager. Unlike gains, declines in the fund s net asset value (NAV) are not shared by the manager but are borne entirely by the investors. This asymmetry is one characteristic of the so-called agency risk that, while present in many types of financial service products, is particularly noticeable in the compensation arrangements that characterize hedge fund investment vehicles. Most funds, however, do have a high-water mark, a provision stating that if the fund s NAV declines, the manager may not charge the incentive fee until the NAV has once again risen above the level at which the previous incentive fee was charged. Furthermore, in the aftermath of the global financial crisis, some managers began offering a claw-back provision, whereby a portion of the incentive fee is placed in escrow and returned to the investors if the fund s NAV declines within a particular period of time. Apart from fees, returns may be further reduced as a result of the fact that some hedge fund managers trade more frequently, incurring higher transaction costs, while others may use derivatives and other financial instruments that are less liquid and are characterized by wider bid/offer spreads. Minimum investment requirements As we have seen, hedge funds are usually structured as private investment pools. As a result, under SEC regulations their investors must meet certain qualifications as to sophistication and net worth, and the number of investors permitted in a fund is limited. In order to achieve an adequate asset base from a limited number of investors, a manager will often establish a minimum investment for entry into the fund. While these minimums vary from fund to fund, they are typically set at around $1 million, with some commanding considerably more. Capacity constraints Many of the inefficient sectors in which hedge fund managers invest are neither broad nor deep; because only so much capital can be introduced without arbitraging away the potential gain from these opportunities, many firms limit the amount of money that they will manage in a particular strategy. Indeed, many successful funds with long track records are closed to new investors. Another form of capacity constraint relates to the number of skilled and talented managers who are capable of exploiting a particular set of market inefficiencies. For these reasons, hedge fund strategies are often described as skill-based strategies. 5

8 THE ROLE OF HEDGE FUNDS IN LONG-TERM INVESTMENT POOLS HEDGE FUND PORTFOLIOS ARE GENERALLY STRUCTURED WITH THREE PRIMARY GOALS IN MIND: DIVERSIFICATION, DOWNSIDE PROTECTION AND POSITIVE COMPOUNDING. DIVERSIFICATION Both modern portfolio theory and practical investment experience confirm that the less correlated two assets are, the greater will be the difference in their return pattern and the greater the reduction in overall portfolio risk from diversification. An allocation to absolute return/relative value strategies, together with an allocation to directional strategies each focused on reducing systematic or market (beta) risk and adding alpha or return from unsystematic risk can reduce overall portfolio risk and improve a portfolio s risk-adjusted returns. In addition, the diversification provided by the two portfolios provides a hedge against the investment risk present in traditional asset classes. The table below shows how various hedge fund strategies correlate with each other and with the S&P 500 Index and Barclays Aggregate Bond Index. The maximum correlation coefficient is 1.0, meaning that returns for different asset groups move in unison. The minimum correlation is -1.0, meaning that returns move in unison, but in opposite directions. A 0.0 correlation means that knowing the direction of one asset s movement will not predict the direction of the other asset s movement. The returns generated by hedge fund strategies over a 22½-year period ending June 2012 have generally exhibited low correlation with the returns of the S&P 500 Index and the Barclays Aggregate Bond Index. While past performance is no guarantee of future success, this low degree of correlation shows how the judicious use of hedge funds may improve diversification and potentially lower the CORRELATIONS OF HEDGE FUND STRATEGIES TO KEY PUBLIC MARKET INDICES January 1990 June 2012 Equity Convertible Equity Market Event- Global Merger Barclays S&P Arbitrage Distressed Hedge Neutral Driven Macro Arbitrage Aggregate 500 Convertible Arbitrage 1.00 Distressed Equity Hedge Equity Market Neutral Event-Driven Global Macro Merger Arbitrage Barclays Aggregate S&P Sources: Bloomberg, HFR volatility of returns within an overall portfolio. 6

9 WORST TO BEST MONTHLY RETURNS: S&P 500 VERSUS HEDGE FUNDS January 1990 June 2012 Numbers in Percent (%) 25% S&P 500 Index HFRI Fund Weighted Composite Index Sources: Bloomberg, HFR DOWNSIDE PROTECTION Relative value or absolute return funds pursue low-volatility investment strategies that earn alpha from conservative, capital-preserving approaches. Directional funds seek returns comparable to those of traditional equity and fixed income funds while reducing downside market risk. Both types of hedge funds seek downside protection by reducing systematic or market (beta) risk and pursuing returns generated through manager skill (alpha). The graphs on this page show the quarterly returns of the S&P 500 Index and Barclays Aggregate Bond Index over the year period from January 1990 through June 2012, arranged from the lowest-return quarter to the highest, compared in each quarter with the return that would have been earned from an equally weighted portfolio of hedge funds based on the HFRI Fund Weighted Composite Index, a widely used benchmark. While the composite risk and return characteristics for the entire period favor hedge funds, there are a number of periods in which traditional asset classes clearly outperformed these strategies. The real value added from hedge funds during this period came not from an attempt to reach for extraordinary returns at the price of higher risk, but rather from the combined effect of the preservation of principal in down markets with consistent upside market participation, leading to a steady compounding of principal. WORST TO BEST MONTHLY RETURNS: BARCLAYS AGGREGATE VERSUS HEDGE FUNDS January 1990 June 2012 Numbers in Percent (%) 20% Barclays Aggregate Bond Index HFRI Fund Weighted Composite Index Sources: Bloomberg, HFR 7

10 VALUE OF POSITIVE COMPOUNDING January 1990 June 2012 Numbers in Dollars ($) $ /90 1/91 1/92 1/93 1/94 1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 U.S. T-Bills % S&P 500 Index Source: Bloomberg Barclays Aggregate Bond Index HFRI Fund Weighted Composite Index POSITIVE COMPOUNDING It is difficult to overstate the importance of positive compounding as a source of long-term excess return. A hedge fund portfolio that captures most of the return from a rising market while avoiding full participation in the losses from a declining market will, over time, outperform a strategy that participates fully in both advances and declines. For example, if an invest ment of $100 declines by 20 percent, the remainder is $80. A recovery of 20 percent on that $80, however, still leaves the investor with only $96 well short of the original $100. For this reason, while the pursuit of gains in rising markets is surely important, it is at least as important to mitigate losses in declining markets so that the subsequent positive compounding can take place from a higher base. As the chart above illustrates, an investment that compounded steadily at the rate of 3-month U.S. Treasury bills plus 6.00 percent a seemingly unspectacular return would have exceeded the return of the S&P 500 over those years, in spite of the tremendous gains recorded by equities during the mid to late 1990s. The reason is that the gains made by the S&P 500 during that period were completely offset by the negative compounding that came as a result of the steep declines in the investment s value during the market collapse of the early 2000s and during the 2008 global financial crisis. Over this period the 10-Year U.S. Treasury yield has fallen from approximately 7.9 percent to 1.7 percent, a level that many believe calls into question the ability of bonds to continue to act as both a diversifier and a key driver of returns in institutional portfolios going forward. As depicted in the chart, hedge fund returns (as measured by the HFRI Fund Weighted Composite Index) well exceeded those of bonds over this time period one of the best periods on record for fixed income investments. Successful hedge funds have benefitted from the value of positive compounding: mitigating losses during declining markets while participating in a significant portion of the upside during rising markets. 8

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12 HEDGE FUND STRATEGIES IN DETAIL IN THIS SECTION, WE DESCRIBE MORE SPECIFICALLY THE MAIN TYPES OF HEDGE FUND STRATEGIES. RELATIVE VALUE/ABSOLUTE RETURN STRATEGIES Equity market neutral (EMN) In these strategies, managers seek to isolate and profit from price movements that are not related to those of the overall stock market. They do this by identifying pricing disparities between two or more instruments with identical or similar characteristics; they then use long and short positions to profit from the difference in value. An example would be a long investment in General Motors and a corresponding short investment in Ford. These offsetting long and short exposures are neutral or equally offset in terms of beta, sector, style, size and other factors. By having two offsetting positions, the manager is eliminating as many market-directional factors as possible, leaving only company-specific risk and return characteristics; hence the name market neutral. These are sometimes also referred to as double alpha strategies, but it is important to remember that alpha can be positive or negative: each position stands on its own, and the investor can make or lose money on both the long and the short position at the same time. Event-driven These strategies, sometimes also called catalyst-driven investments, are based on factors that are largely independent of general market movements. Returns from event-driven strategies are based on the manager s understanding of business events such as mergers (merger arbitrage), bankruptcies (distressed investing), financial restructurings (capital structure arbitrage) and reorganizations, buyouts and spin-offs (special situations). Managers attempt to ascribe probabilities to the likelihood of these events unfolding and to profit from the relative impact these events have on securities across corporate capital structures. The uncertainty about the resolution of such events enables managers to earn a risk premium for providing liquidity, and to exploit temporary mispricings among the relevant securities. 10

13 This pie chart shows how the greater than $2 trillion in hedge fund assets are broken out by strategy. Directional strategies (long/short equity and global macro) account for about 32 percent of hedge fund assets, with relative value strategies accounting for the remainder. Fixed income arbitrage This term encompasses a variety of sub-strategies involving fixed income securities, including G7 1 government debt, U.S. government and agency debt, corporate debt, municipal debt, mortgage-backed securities, asset-backed securities, sovereign emerging market debt and related derivatives. Managers profit by identifying and exploiting valuation anomalies that occur among these securities as a result of mispriced credit, volatility or liquidity premiums. To cite an example from the U.S. Treasury market, on the run (that is, newly-issued) Treasury securities may trade at a higher price than off the run (older) Treasury securities because they are traded more frequently and thus have better liquidity. Some of the more common trades in this strategy are yield curve arbitrage, basis trading and mortgage arbitrage. DIRECTIONAL STRATEGIES Long/short equity Managers employing these strategies (also known as equity hedge or hedged equity) buy equity securities that they believe to be intrinsically undervalued and use short selling to position themselves to profit from a price decline in securities they deem overvalued. The manager s analytical process may be top-down focusing HEDGE FUND INDUSTRY SEGMENTED BY STRATEGY December 2011 Numbers in Percent (%) Other 8% Multi-Strategy 13% Merger Arbitrage 1% Fixed Income 12% Event-Driven 10% Equity Market Neutral 2% Source: BarclayHedge on sectors, industries and/or countries or bottom-up, emphasizing individual company or security selection. Because they seek to capture returns on both the upside and downside and have beta exposure, they are considered to be market directional. Global macro In this strategy, managers forecast shifts in markets due to economic, political, or government-related events and then take positions across capital market sectors stocks, bonds, currencies and commodities to profit from their foresight. Global macro managers typi cally fall into two camps: discretionary and systematic. Discretionary managers establish a top-down view of the world, assess its implications on global markets and use their own subjective judgment to select investments and execute trades. Systematic managers employ quantitative, computer-driven models to trade across liquid markets globally based on observed price behavior. In systematic Equity Long/Short 24% Global Macro 8% Convertible Arbitrage 2% Distressed Securities 7% Emerging Markets 13% trading, portfolio decisions are based on quantitative models rather than human judgment. Global macro strategies, which are market directional, are often characterized by higher degrees of portfolio turnover and volatility. These are a few of the more frequently used hedge fund strategies. The sector is, however, tremendously creative and different managers will often have developed their own special approaches to each of these investment strategies. 1 Russia is generally categorized as an emerging market country, and so its debt is not included in this category. 11

14 THE CURRENT STATE OF THE HEDGE FUND MARKET ACCORDING TO HEDGE FUND RESEARCH, INC., AS OF THE END OF 2011 ABOUT $2 TRILLION WAS INVESTED IN HEDGE FUNDS (BEFORE CONSIDERING THE EFFECT OF LEVERAGE), MANAGED BY MORE THAN 9,500 DIFFERENT MANAGERS. WHILE THIS AMOUNT REPRESENTED A SMALL PERCENTAGE OF THE VALUE OF THE WORLD S EQUITY, FIXED INCOME AND CASH MARKETS LESS THAN 1 PERCENT OF THE GLOBAL LIQUID CAPITAL MARKET 2 THE IMPACT OF HEDGE FUNDS ON TRADING VOLUMES HAS BEEN IMMENSE, WITH AS MUCH AS ONE-QUARTER OF TOTAL ANNUAL TRADING VOLUME IN THE LIQUID CAPITAL MARKETS ATTRIBUTABLE TO THESE STRATEGIES. 3 2 McKinsey Global Institute 3 Greenwich Associates Of even greater impact is the innovation in new financial instruments that has been fostered by hedge fund managers over the last 30-plus years, from exchange-traded options in the 1970s to credit derivatives in the late 1990s. Managers have relied on this ever-expanding toolkit of new financial instruments to develop and enhance their strategies. Hedge funds play a prominent role in the investment portfolios of endowed nonprofit institutions. The 2011 NACUBO-Commonfund Study of Endowments (NCSE) found that 53 percent of the study s 823 participants reported having investments in hedge funds, up from 23 percent in fiscal Other types of nonprofit institutions have also reported growth in hedge fund use, as shown in the table on page 13. The vehicles through which investors obtain access to hedge funds private entities organized as partnerships, corporations or other limited liability entities open only to a limited number of accredited or qualified investors qualify for exemption from many of the regulations and disclosure requirements under which funds regulated by the SEC operate, and are often domiciled offshore to offer their non-u.s. and U.S. tax-exempt investors certain tax advantages. Recent legislative changes will, however, result in more regulation for many of these funds. 12

15 Under the Dodd-Frank financial reform legislation passed in 2010, most investment advisers, including those to hedge funds, are required to register with the SEC and submit to its informational disclosure and reporting requirements. Advisers will be required, among other things, to appoint a compliance officer, establish formal policies and procedures and submit to random audits by the SEC. Under the new regulations, an adviser will be able to remain exempt from registration if it manages private funds only and has total assets under management of less than a specific amount; it will still, however, be required to comply with some of the reporting and informational requirements of the new law. Managers with smaller amounts under management will generally be required to register with and report to state securities regulators in the states where they do business. Because the specific SEC requirements are still being developed, their ultimate impact is unclear. Although a number of larger advisers are already registered and will incur no additional burdens, smaller managers with limited staff may be the most affected by these regulations. It is generally assumed that the cost of compliance with the new requirements will have an effect on the economics of start-ups and smaller firms that have historically been among the sector s most innovative. $ in Millions GROWTH OF THE HEDGE FUND MANAGEMENT INDUSTRY $2,400 2,000 1,600 1, Assets Source: HFR USE OF HEDGE FUNDS BY NONPROFIT INSTITUTIONS FY2000 FY2011 As of December 2011, there were nearly 16 times as many hedge funds as there were in 1990, and they managed nearly 52 times as much money. Meanwhile, hedge funds still represent less than 1 percent of the global liquid capital markets (including equities, fixed income and cash). However, it is estimated that hedge funds account for as much as one-quarter of the total annual trading volume in these liquid capital markets. Number of Funds 12,000 10,000 Fiscal Year Educational Endowments* Foundations Operating Charities Healthcare Organizations Sources: Commonfund Benchmarks Studies, NACUBO-Commonfund Study of Endowments *Commonfund Benchmarks Study of Educational Endowments data for FY2000 FY2008; NCSE data for FY2009 FY2011 In FY2004 and FY2005, Commonfund published a combined Benchmarks Study of Foundations and Operating Charities. In FY2006, the stand-alone Commonfund Benchmarks Study of Operating Charities was introduced. 8,000 6,000 4,000 2,000 0 Number of Hedge Funds & Funds of Funds 13

16 EVALUATING, CHOOSING AND MONITORING HEDGE FUND MANAGERS INVESTING IN HEDGE FUNDS SHOULD NOT SOLELY BE A QUEST FOR SPECTACULAR RETURNS; RATHER, THE INSTITUTION MUST APPROACH THE PROCESS WITH A THOROUGH UNDERSTANDING OF ITS OWN NEEDS AND THE SEQUENCE OF TASKS INVOLVED. THERE IS A LARGE PERFORMANCE DISPARITY BETWEEN TOP- AND BOTTOM- QUARTILE HEDGE FUND MANAGERS, BUT GAINING ACCESS TO THE LEADING MANAGERS IS ONLY THE BEGINNING. DUE DILIGENCE, PORTFOLIO CONSTRUCTION AND ONGOING MONITORING OF THE MANAGERS SELECTED ARE ALL CRUCIAL TO SUCCESS. WHERE AN INSTITUTION LACKS THE INTERNAL STAFFING AND EXPERTISE TO PERFORM THESE TASKS, IT MAY BE PRUDENT TO CONSIDER USING FUNDS OF FUNDS OR OUTSOURCED SERVICE PROVIDERS. KNOW THYSELF The process should begin with a thorough reexamination of the institution s investment policy, including risk tolerance, spending requirements, return objectives, time horizon, and other relevant circumstances. This stage of the process will determine the construction of the hedge fund portfolio and assist in the allocation between strategies that increase returns and those that improve portfolio diversification and reduce portfolio risks. The result will be the establishment of realistic expectations for this segment of the portfolio as the board and investment committee answer these questions, among others: > > Are you seeking to reduce the variability of portfolio returns? > > Are you trying to diversify your fixed income allocation? > > Do you want to preserve capital by obtaining downside protection in falling markets? > > Do you need to increase your long-term spending rate? ALLOCATE The next step is to determine the appropriate allocation to those hedge fund strategies that, taken together, are likely to meet your investment objectives. As the Investment Style Risk/ Return Characteristics chart on the opposite page shows, marketdirectional strategies historically have had different risk and return characteristics than relative value or absolute return strategies. As an example, consider the hypothetical hedge fund portfolios illustrated in the chart on the bottom of page 16. Portfolio A is composed solely of relative value strategies. Portfolio B is composed solely of market directional strategies. Finally, Portfolio C provides an equivalent 50/50 mix of both relative value and directional strategies. Because these strategies have different risk and return characteristics, they can be used to construct very different portfolios. Portfolio A provides the lowest risk and return profile, Portfolio B the highest, and Portfolio C is in the middle. The determination of which portfolio construction is most appropriate depends on your institution s investment objectives. It is important to bear in mind, too, that the allocation to hedge fund strategies and the funds selected to implement these allocations must ultimately work in harmony with the institution s overall portfolio. How many hedge fund managers are required for a robust and diversified portfolio? The answer is not precise, but as shown in the chart on page 16, 14

17 bottom right, we believe that a portfolio of managers is optimal. As elsewhere in investment management, diversification provides a strong defense. While the strategies used by hedge fund managers may show low or negative correlation both to traditional investments and to one another, differ ent strategies tend to thrive in different political, economic, or market conditions and, as has often been observed, conditions can change abruptly. HEDGE FUND STRATEGY DIVERSIFICATION Numbers in Percent (%) Source: HFR Convertible Arbitrage Global Macro Distressed Equity Market Neutral Merger Arbitrage Event-Driven Equity Hedge INVESTIGATE With a secure knowledge of the institution s risk tolerances, investment goals, and desired portfolio structure, the board and investment committee can now proceed to select a group of managers to meet these objectives. In traditional investment sectors, a fund s performance against a benchmark is considered a major factor in evaluating a manager. But in the world of hedge fund managers, it is harder to distinguish between skill and luck. Key fund performance metrics are not generally made public, and while benchmarks exist they are not without weaknesses. Databases such as TASS, Altvest, HFR, CSFB/Tremont, MSCI/Barra, and Standard & Poor s provide benchmarks for various hedge fund strategies, but only a few offer an investable index, and their index and benchmark constructions (investable or not) vary substantially. Some databases weight their indices by assets, regardless of whether they represent an investable group, and others equal-weight their indices. Because database reporting is voluntary, underperforming managers tend to drop out and thus the performance indices suffer from problems of survivorship and self-selection bias. Some databases (Top) Hedge fund strategies and investment returns vary widely. The chart illustrates the diversification and fluctuation in returns in seven different strategies over the 10-year period from 2002 to (Below) This chart maps the risk and return characteristics of several principal styles of hedge fund investing. Hedge fund strategies fall into two main groups: relative value and directional. Relative value, or absolute return, strategies tend to be market neutral, seeking to earn alpha by taking spread and event risk instead of market direction risk. Directional strategies are market directional, tend to be more volatile and offer the potential of higher returns than relative value strategies. INVESTMENT STYLE RISK/RETURN CHARACTERISTICS January 1990 June 2012 Annualized Return 14% Source: HFR Equity Market Neutral Relative Value Merger Arbitrage have no minimum threshold for assets under management and therefore may include many small, retail-oriented funds that do not represent the institutional investment opportunity set in either their non-investable or investable universes. Perhaps more important, because of the dynamic nature of the hedge fund business, database rankings can Distressed Convertible Arbitrage Annualized Standard Deviation Event-Driven Directional Global Macro Equity Hedge 0% 2% 4% 6% 8% 10% change quickly, as can the universe of managers. Manager turnover is high; according to HFR, the total number of hedge funds was 9,500 at the end of calendar 2011 but it is estimated that 775 managers went out of business in 2011 while more than 1,100 entered the 15

18 (Left) The mix of strategies in a hedge fund portfolio can be tailored to meet an institution s particular risk and return objectives. In this chart, Portfolio A is composed solely of relative value strategies and offers the lowest risk/return profile. Portfolio B is composed solely of directional strategies and provides the highest risk/return profile. Portfolio C provides an equivalent 50/50 mix of both along with a risk/return profile roughly in the middle. (Right) For hedge funds, the optimal number of managers is greater than for most other asset classes. This chart suggests that adding hedge fund managers to a portfolio leads to greater consistency of returns, with the optimal number of managers being in the range of 15 to 20. field. Moreover, due to the pronounced differences among the strategies used and the types of risks involved, many managers have short track records and performance rankings are, therefore, less meaningful. With this as background, it can safely be asserted that manager due diligence involves both qualitative and quantitative analysis neither is sufficient in itself. On the qualitative side, on-site interviews of fund principals and others in the firm are necessary in order to obtain a thorough understanding of the institution. Particular areas of focus should include the following factors, among others: > > Ownership > > Depth, quality, experience and background of the management team > > Investment and business philosophy > > Manager capacity > > Investment process > > Principals commitment of their own resources to the fund > > Average tenure and staff turnover > > Compensation and incentive structure > > Consistency of the manager > > Terms of the fund > > Liquidity provisions > > Fees > > High-water marks > > Ability to provide acceptable levels of transparency > > Trading, operations/back office, legal and risk controls The quantitative analysis that must be undertaken for individual manager due diligence is substantially the same as that performed to build the portfolio. The following, at a minimum, should be performed for each fund under consideration: > > Statistical analysis of historical returns > > Factor or macro exposure analysis > > Performance attribution > > Analysis of performance relative to benchmarks and peer groups > > Analysis of drawdowns > > Stress test analysis of various risk measures at different points in time An examination should also be undertaken of your portfolio s overall risk and return characteristics with and without the inclusion of the specific manager being evaluated. The selected strategies must be studied in HYPOTHETICAL HEDGE FUND STRATEGY RISK/RETURN January 1990 June 2012 DIVERSIFICATION OF MULTI-MANAGER PORTFOLIOS January 2007 December % 30% Annualized Return Portfolio A (100% Relative Value) Portfolio B (100% Directional Value) Portfolio C (50% Directional/ 50% Relative Value) Monthly Standard Deviation % 2% 4% 6% 8% 10% Annualized Standard Deviation Number of Managers Source: HFR Avg. SD +1 Avg. Standard Deviation Sources: Commonfund Hedge Fund Strategies Group, HFR Avg. SD -1 16

19 combination, weighing managers and strategies against one another and considering the weightings of each manager in the portfolio. Managers must be selected to achieve a balance among different kinds of experience, different perspectives and different ways of making decisions. For each manager and for the portfolio of managers under various possible combinations, the investor will need to model and analyze: > > Return patterns > > Sources of alpha and beta > > Correlation among and between managers and strategies > > Aggregate levels of volatility > > Downside deviation > > Maximum drawdown > > Upside/downside capture > > Value at risk (VaR) > > Gross long/short exposures > > Leverage > > Counterparty risk > > Market and factor exposures (such as credit sensitivity) > > Liquidity Only when all the questions have been answered and the risk and return characteristics of the proposed allocation are found to be in accord with objectives can implementation proceed. MONITOR AND MANAGE After the managers have been chosen and hired, continued monitoring is necessary. Economic and market conditions change, and managers adjust their strategies accordingly. You and your institution will need to conduct a rigorous ongoing monitoring process to ensure that your allocation remains consistent with your original objectives and that the exposures and risks in your allocation remain appropriate and within the parameters you have specified. This process in effect reenacts the work that was done in building the port folio and selecting the managers in the first place we like to refer to this process as re-underwriting managers. Because of the unconstrained nature of hedge fund investment strategies, there are few legal assurances; it is therefore up to investors to remain informed about managers exposures and trading practices. The following are a few of the questions to be considered by your institution: > > Is there a maximum or minimum amount of assets under management that you require for your institution to remain invested in a particular strategy? > > What level of correlation with broad markets do you expect, based on the strategies you select, and how will you ascertain that the manager s performance is consistent with that level? > > How much illiquidity, leverage and volatility will you accept, and how will these be measured? > > What is the range of annual return that you are targeting for your funds? > > What is the maximum drawdown or loss that you would find tolerable? > > What requirements do you have for the manager in terms of track record, overall assets under management, investor base and previous losses? > > Are onshore or offshore UBTI 4 con siderations important to your institution? > > What kinds of communications, reports and other information do you require? The ability of your institution to engage in the kind of ongoing portfolio and manager monitoring implied by these questions is largely dependent on the degree of transparency provided by the manager through its prime broker, administrative service provider or thirdparty data aggregator. Data that should be regularly checked include: > > Amount of leverage in the portfolio > > Counterparty risks > > Liquidity of the underlying portfolio securities > > Process for the valuation of positions > > Interest rate risk > > Credit sensitivity > > Basis risk > > Spread risk Analysis of portfolio positions can help an investor to monitor risks and port folio exposures and to uncover any shift that may be occurring in investment strategy. Style drift where a manager deviates from its stated strategy or core area of expertise can deleteriously affect performance and cause divergences between expected and realized performance. In addition to monitoring each manager s portfolio and its effect upon the aggre gate hedge fund allocation, investors need to remain aware of organizational or operating changes at the firm for instance, personnel changes or growth in assets under management that could distract management and adversely impact performance. Finally, you should expect that at some point you will adjust or make changes in your manager lineup that could necessitate a rebalancing of your allocation. With that possibility in mind, you should maintain a back-up list or pipeline of managers for further consideration in the future. This can be a time-consuming task in itself, since the talent inventory in the hedge fund universe is diverse and constantly changing. 4 Unrelated Business Taxable Income. See U.S. Internal Revenue Service Publication 598, Tax on Unrelated Business Income of Exempt Organizations (March 2010), 17

20 IMPLEMENTATION: BUY OR BUILD? AN INSTITUTION ENTERING THE HEDGE FUND SECTOR FACES A CLASSIC BUSINESS DECISION: TO MANAGE THE PROCESS IN-HOUSE OR OUTSOURCE IT. A CASE CAN BE MADE FOR EITHER APPROACH, AND ALSO FOR A COMBINATION OF BOTH. A significant proportion of hedge fund investments are placed through funds of funds. As the name indicates, a fund of funds takes responsibility for the screening and selection of managers and aggregates the selected funds into specifically designed programs in which investors can participate. Many firsttime investors have chosen funds of funds for their initial foray into hedge funds for the simple reason that their institutions lack the strong analytical and monitoring capabilities and the access to top-performing managers that are required to build a robust and diversified hedge fund portfolio. On the other hand, many institutions particularly those with sizeable assets successfully use their own in-house capabilities to manage their portfolios of hedge funds. Those institutions have experienced staff dedicated to this sector as well as the technology and time necessary for due diligence and portfolio monitoring. These direct investments are made either through existing fund vehicles managed by the hedge fund manager or through customized separately managed accounts. As the name implies, separately managed accounts are investment vehicles that are either legally owned or controlled by the investor the assets are segregated and the investor retains control over the hedge fund investments. This approach is appealing for several reasons: > > Customization: The return and risk properties, fees, liquidity profile, market and geographic exposures and reporting can all be tailored to the investor s specific requirements. > > Transparency: Disclosure of the hedge fund manager s investment activities and the underlying security holdings allows for better risk monitoring and management. > > Control and Liquidity: A segregated account allows the investor to choose counterparty relationships, insulates the investor s assets from the redemption activities of other investors, and enables the investor to terminate the hedge fund manager, if they so choose. Which approach should your institution adopt? Viewed analytically, the rationale for keeping the process in-house is that it enables greater economy and control. It is true that dedicated staff, due diligence and portfolio monitoring add overhead costs to the investment operation, but the additional layer of fees charged by funds of funds is avoided. And managing in-house gives the institution direct control over hedge fund selections and the ability to precisely tune the allocation to fit the investment objectives. The disadvantages of an inhouse approach hinge on the special operational problems of managing an allocation to hedge funds. This is a labor-, time- and cost-intensive process that, for many institutions, does not fit seamlessly into the existing investment operation. Hedge fund strategies demand specific analytical techniques and quantitative tools and, because a given fund s methods are often unique to that particular manager, the analysis becomes a highly situation-specific task with a number of qualitative dimensions. 18

21 To take one example, risk management and portfolio monitoring are challenging due to the lack of liquidity and transparency. The funds administrators, prime brokers, trading facilities and legal entities have to be monitored and evaluated together with the strategies they use, the investments they make and the results they report. Not every institution can attract and retain the staff required to do this necessary work. On a more fundamental level, gaining access to certain funds can prove challenging for all but large, experienced and well-recognized investors. Some funds may be closed to new investment. Others may have set high hurdles for entry; some have $1 million minimums but many set their minimums substantially higher. These limitations can create difficulties in building a diversified portfolio since your institution may not have sufficient assets to invest in a suitable number of managers. Given the investment acumen and significant operational, risk management, technological and legal resources required to source, assess, select and monitor direct hedge fund investments, an increasing number of institutional investors are embracing a hybrid of the fund-of-funds and direct models. For them, engaging a professional investment manager to serve as an adviser and provide fiduciary oversight is an appealing proposition. Often these investment advisers are fund-offunds managers, able to leverage their substantial existing portfolio management, infrastructure and due diligence resources. Typically, investors select either a discretionary relationship where investment decisions are the responsibility of the investment adviser, or a non-discretionary structure where the investor directs investment decisions. In evaluating any fiduciary investment partner, an institutional investor should keep these important criteria in mind: > > The investment manager must have the ability to understand the full range of strategies, instruments and techniques that hedge funds use. It should be able to demonstrate a proven process for analyzing the quantitative and qualitative variables of a hedge fund strategy, form a well-reasoned judgment about its return potential and risks and experience, and exhibit a track record in building hedge fund portfolios. > > The investment manager must also have the capabilities to handle the operational requirements of hedge fund investing: the legal due diligence, negotiations and documentation, accounting and financial reporting, and cash flow management. > > Finally, investment managers with sophisticated resources should possess tools (including relationships with prime brokers and third-party aggregators) that provide it with significant capability to look through into individual manager portfolios, providing the investor with improved oversight. Investors should look for a long and successful record of experience, a strong investment process, independent investment and infrastructure due diligence processes, high quality staff, aligned interests, an ethical culture and robust reporting. 19