abcd
Absolute Return Funds and Institutional Investors
Robert Howie
23 June 2003
The Caledonian Hilton Hotel, Edinburgh
Introduction
 Absolute Return: e.g. 10% p.a.
 Relative Return: e.g. MSCI World + 1% p.a.
 Think of “absolute return” strategies as “cash plus”
 Typically this means hedge funds
 Agenda:
 Why some institutional investors are investing in these
strategies, and others not
 What is happening in the hedge fund industry
 Some research into hedge fund returns
Survey of UK Life Insurers
 Questionnaire on hedge fund investing to all
Appointed Actuaries
 38 responses (6 nil responses)
 16% already had hedge fund investments
 16% expected to make investments in next 3 years
 31% would never invest in hedge funds
 Allocations very small and expected to stay so
Hedge Fund Strategies Currently Utilised
Number of Respondents
3
2
1
0
Convertible
Arbitrage
Event Driven
Fixed Income
Arbitrage
Global Macro
Long/Short Equity Managed Futures
Fund of Hedge
Funds (MultiStrategy)
Hedge Fund Strategies Likely to be Utilised in
Future
Number of Respondents
5
4
3
2
1
0
Convertible
Arbitrage
Event Driven
Fixed Income
Arbitrage
Global Macro
Long/Short Equity Managed Futures
Fund of Hedge
Funds (MultiStrategy)
Currently invest
Possible investors
Unlikely investors
Fee levels
Lack of in-house
management
experience
Lack of
transparency
Risk profile of
hedge funds
0.5
Poor expected
performance
Liquidity issues
Lack of market
capacity
Inappropriateness
of asset class
Admissibility
Significance (Average response)
Restrictions Preventing Hedge Fund Investments
3
2.5
2
1.5
1
`
0
Attractive Attributes of Hedge Funds
100%
90%
% of Respondents
80%
70%
60%
50%
40%
30%
20%
10%
0%
Good prospective performance
Low volatility of performance
Currently invest
Low prospective drawdowns
Possible investors
Unlikely investors
Total
Diversification with other asset
classes
Update on Hedge Fund Industry
 New funds no longer closing on launch
 Development of incubator/seeding programs for new funds
 Increase in the rate and number of closures
 Many failures caused by operational problems
 Others close because they fail to raise sufficient assets and
become uneconomic
 New funds continue to launch
 Layoffs in traditional fund management and investment
banks adding to pool of hedge fund managers
Hedge Fund Transparency
 Institutional investors are used to position level
transparency
 Hedge fund managers rarely supply this information
to all investors
 Short positions are particularly protected
 Short positions have unlimited losses, and managers
sometimes feel vulnerable to competitive exploitation
 Managers believe this is information is too sensitive
Hedge Fund Transparency
 Investor Risk Committee of the International
Association of Financial Engineers objectives for
disclosure:
 Risk monitoring – no undue risks
 Risk aggregation – ability to use individual manager data to
analyse portfolios of hedge funds
 Strategy drift monitoring – ability to determine whether
manager is adhering to stated style
Academic research on modelling hedge fund
returns
 Many studies on explanatory models
 Hedge fund returns only partially explained by traditional
linear models
 Option-like return payoffs
 Expect further research in this area
Heterogeneity of hedge funds
Regression Analysis of Hedge Fund Index Returns Factors




Equity prices (S&P 500)
Long Government Bond prices (Lehman Long Gov)
Credit (Lehman Long Credit less Lehman Long Gov)
Growth vs value (Russell 1000 Growth less Russell
1000 Value)
 US short rate (% move in 1 month interest rate)
 Implied volatility (% move in CBOE OEX Volatility
Index)
Regression Analysis of Hedge Fund Index Returns –
Main Results
 Many of the correlations fairly high
 Betas are generally lower (notable exception is credit)
 Many had a high correlation with equities (>0.6)
 Notably Equity Hedge and Event Driven
 Lower betas
 Many strategies exhibited strong correlation to credit
 Performed badly when credit deteriorated
 Most pronounced in the 1997 to 1999 period
 Incorporates the 1998 crash when credit spreads increased
significantly
 Also some significant betas in this period
Regression Analysis of Hedge Fund Index Returns –
Main Results
 Many strategies have shown a high negative
correlation to VIX Volatility
 Especially in the most recent time period 2000 to 2002
 Particularly Equity Hedge and Event Driven
 Factor has very strong negative correlation to equity returns
Regulation of Hedge Funds
 UK
 Marketing
 Unlikely that marketing to retail investors will be allowed
 Market Impact
 Short-selling not discouraged, but increased transparency
desirable
 Other Countries
 Mixture of approaches
 Sometimes driven by tax considerations
Funds of Hedge Funds
 Many investors choose to delegate
 Hedge fund selection and due diligence
 Portfolio construction
 Monitoring
 Fund of hedge fund managers bring




Diversification
Market access / capacity
Improved liquidity
Lower minimum investments
 Extra layer of fees
The role of actuaries
 Limited role in hedge fund industry
 Unlikely to change
 Actuarial consulting firms focusing on funds of hedge funds
 Potentially important role advising on the strategic
allocation to hedge funds
 More education needed?