Sovereign Wealth Funds: An Oil to Financial Assets Migration

Bernd Scherer, a professor at EDHEC Business School, wrote an article in the Winter 2011 issue of the Journal of Alternative Investments about Sovereign Wealth Funds (SWFs).  Most of the largest SWFs (8 of the top 10) are funded by oil revenues and need to diversify their asset base.  The funds try to find an optimal investment portfolio.  The author concludes that the asset allocation should include an equity growth and oil price hedging positions.  To hedge oil assets, the SWFs should use fixed income or hedge fund investments as they are negatively correlated.  Funds that have low financial assets compared to their physical assets should have a more risky asset allocation.  Those SWFs in the opposite situation should be more conservative in their asset allocation.

You can access the article for details, charts and exhibits here.

GIPS: Global Standard for Reporting Fund Manager Returns

The CFA (Chartered Financial Analyst) Institute created and published the Global Investment Performance Standards (GIPS) for investment management firmsin the September/October 1987 issue of the Financial Analysts Journal.  They would apply to investment advisers, certain brokers, mutual funds and consultants.  The objectives of GIPS reporting are to:

• Create a minimum standard method for calculating and presenting investment returns for global comparisons
• Ensure data are fair, accurate, consistent and timely
• Promote fair competition and eliminate barriers to entry
• Aid global self-regulation
• Acknowledge caveats for GIPS:  account selection, survivorship and measurement period biases

To achieve this, firms must follow these requirements:

• Consistent data integrity
• Uniform methods of calculation
• Complete and accurate composite construction
• Disclosure of any non-compliant history
• Reporting of long term performance is required

Additional information:

• Returns are calculated on a firm-wide basis.  They must be for at least five years and build up to ten years.  Obviously, if a firm is not five years old, then data from the inception needs to be reported.
• Performance must be presented with composite returns that have common objectives or strategies
• Managers should inform investors of any benchmark indices used for performance comparisons

Please note that compliance is purely voluntary.  GIPS promotes transparency, international comparability and best practices.  Full details may be found at http://www.gipsstandards.org/.

Hedge Fund Indices: Can They Be Used as Performance Benchmarks?

One of the requirements of institutional investors such as endowments, foundations and pension funds is a performance benchmark for a fund.  For mutual funds, there are a series of well-defined indices that serve in this capacity.  For Large Cap Equity in the US, there is the S&P 500 or Dow Jones Industrial Average.  The Small Cap Equity benchmark in the US is the Russell 2000.  A country may have an index such as Great Britain's FTSE 100 or Japan's Nikkei 225.  Bonds have their own indices based on their type"  US Treasury, High Yield, Mortgages, etc.  This allows the investor to compare a fund's returns relative to their investment universe's benchmark and find their outperforming and underperforming managers.

It is more difficult to find a proper index for hedge fund managers.  The more famous ones are the Dow Jones Credit Suisse, Hennessee Group, Eurekahedge, Barclay and MSCI.  Mutual fund indices are transparent to the public.  On the other hand, the opaqueness of hedge funds creates issues with finding a proper index for a manager.  The following issues are highlighted in Mark Anson's Handbook of Alternative Assets which is one of the source books for the CAIA program.

• Indices do not contain the same hedge funds
• Survivorship bias is a problem for newly created indices.  Since surviving funds are still in business because of superior returns, they cause the index to overestimate the return of all funds by 2.6% to 5% annually.  Most funds that close do not report their returns as they have more important responsibilities such as returning cash to their investors.  Survivorship bias may not affect indices' return history because the failing managers' performance data are retained in the historical data.
• Instant history bias occurs when the manager, after a period of good performance, decides to add his fund to the index.  Unlike mutual funds, reporting is voluntary in the hedge fund industry.  In addition to the current period, the manager will provide his historical performance.  This causes backfilled performance to be overestimated by 1% to 5% per year. This does not affect indices are they do not re-state historical numbers.
• Liquidation bias increases the performance of indices as failing or closing funds will no longer report their returns.
• Each index has its own definition for categorizing hedge fund investment strategies.  Also, managers are able to use a different strategy if the original strategy is not working or does not have enough investing opportunities.
• Access bias happens because many funds are closed to new capital.  A complete index would have open (investable) and closed (non-investable) funds.  This affects indices that report returns on a daily basis as their fund universe is restricted.  They can only include investable managers that do not invest in illiquid assets.  Because of this, investable indices underperform noninvestable indices.  The better managers manage funds that are oversubscribed i.e. there are too many investors with too much capital.
• The 2 and 20 fee structure can distort index returns.  Indices take into account fees when calculating performance.  Incentive fees are paid out annually but indices report on a monthly basis.  The incentive fees have to be estimated each month.  The total of the monthly fees may be different that the actual fee.  Also, the funds in the index may have different fees.  They can range from 1 and 15 to 3 and 50.
• Indices' components and calculations are different
• Turnover due to funds that start reporting and high attrition rate
• Including Managed Futures funds
• Type of index:  asset versus equally weighted 

Anson's summary concludes, "Perhaps the best way to choose a hedge fund index is to first state clearly the risk and return objectives...With this as their guide, investors can then make an informed benchmark selection."

Insider Trading Investigation: Galleon Partners Update

Galleon Partners was the first name to fall in the FBI's insider trading investigation.  Two more former employees entered guilty pleas.  They were the 18th and 19th people.  A portfolio manager named Adam Smith plead guilty to profiting from non-public material information about three mergers and earnings reports from two companies.  All tips were about companies in the technology sector.  A trader named Michael Cardillo was plead guilty to insider trading on six stocks.

There articles are from hedgeworld.com, reuters and finalternatives.com.

Troubles at Goldman Sachs Asset Management

Investment management is a tough business.  Just ask Goldman Sachs.  Albourne Village alerted me to two articles about the troubles at Goldman Sachs Asset Management (GSAM).  There has been turnover of key personnel at the top.  In eight years, there have been eight different heads of GSAM.

Both traditional and alternative funds have struggled.  Hedge fund assets under management (AUM) have declined from $29.5 billion in 2006 to $19.5 billion in September 2010.  Equity and bond mutual funds have trailed the average performance over the three, five and ten year benchmarks according to Morningstar.  The total decline in AUM is $71 billion in 2010 including the Nevada Public ($600 million) and the Kern County Employees' Retirement Systems ($347 million).

Goldman Sachs may be seen as having reputational risk from its high profile in the news from the Facebook deal, the SEC civil suit for its involvement in Abacus and its collateral calls on credit default swaps with AIG.

You may access the articles here and here.

Are Fund of Funds Dead?

From time to time, I will see an intelligent article written by another blogger.  I recently read a posting written by Simon Kerr about the Eurekahedge report for 2010.  The report showed that assets were flowing back into hedge funds but had not recovered for funds of funds.  Other points that he makes are:

• For the past three years, funds of funds have a negative return while being as risky or volatile as single manager hedge funds
• North American institutional investors are confident enough to invest in hedge funds directly.  They no longer have to rely on funds of funds expertise.
• Funds of funds are supposed to supply due diligence to avoid blow-ups and investing in  underperforming hedge funds.  They failed to do that in 2008.
• For other regions, there is still a place for funds of funds.  The example that he gives is that Japanese investors will need a fund of funds to invest in North American hedge funds.

The complete post is here.

Hedge Fund Fees: A Study on Manager Behavior

There was an article in the Journal of Alternative Investments regarding the effect of hedge funds' fees and the risk-taking behavior of fund managers.  It was written by Andrew Clare and Nick Motson.  Fees are controversial because of the size of them and because they may not provide the proper incentives to managers.  From 1994 - 2006, performance fees averaged 5.15% per year.  Adding on the standard 2% management fee leads to the investor paying the manager 7.15%.  The average equity mutual fund manager's fee is 1.3%.  Also, the manager participates on the upside but not on the downside.  The floor is the management fee.

Risk is defined as the volatility of returns of the portfolio.  A high risk fund has the possibility of having wild swings in returns.  A low risk fund will plod along at the same conservative rate.  The article asked if managers were below their high watermark, would they invest in riskier assets to earn a performance fee?  Conversely, if managers were after their high watermark, would they invest in less risky assets.

Clare and Motson found that managers adjusted the risk profile of their funds depending on their performance in the first half of the year.  Managers who were 15% or more above their high watermark at that time decreased their risk to lock in their performance fees.  Managers who were 10% or more below their high watermark also decreased their risk.  Since managers are large investors in their own funds, they would want to preserve their capital.  Also, there is a chance that other investors may withdraw their money. Managers that were in the middle increased their risk to try to earn incentive fees.

Another finding of Clare and Motson was that hedge fund managers are affected by their relative performance versus other managers.  They categorized managers after their performance in the first half of the year.  Those managers that were in the top half decreased their risk to maintain their rankings.  The managers in the bottom half increased their risk to move up in the rankings.  This is similar to the behavior of mutual fund managers.  It is called tournament behavior.

The article may be found here.

Hedge Fund Manager Fees: 2 and 20

Unlike mutual fund managers, hedge fund managers are paid from two fees:  management and incentive/performance.  Managements fees are based on assets under management and range from 1% to 4%, with the standard being 2%.  This can be paid out quarterly, semi-annually or annually.  The average equity mutual fund management fee is 1.3% and no performance fee.

Incentive fees are based on fund returns and are paid out on an annual basis.  The standard is 20% of profits although they can range up to 50%.  The fee is calculated against a high water mark at the end of the year.  For example, the net asset value (NAV) of the fund is at $100 at the start of the year.  If the NAV is $115 at the end of the year, the fee is calculated on the $15 gain i.e.e $15 x 20% = $3.  If there is no increase in the NAV, the manager receives no performance fee.  In the event that the fund manager loses money in one year, the high water mark may carry over to the next year.  For example, the NAV starts at $100 and goes to $90 in year one.  In year two, the NAV finishes at $110.  The performance fee is calculated off the initial mark i.e. ($110 - 100) x 20% = $2.  For managers that have large losses, they would have the incentive to reset the high water mark.  The best way to do this is to launch a new fund.  Of course, this would anger the original investors and the new fund would get most of the new attention from the manager.

Some funds have hurdle rates.  Incentive fees are not paid until the fund's return have met or exceeded the rate.  It may be based on an agreed upon rate, LIBOR or the yield on US treasury bills.  There are two types of hurdles:  hard and soft.  The hard hurdle is calculated only on returns above the hurdle rate.  Soft hurdles are calculated on the whole return.  For example, the beginning NAV is $100; the ending NAV is $120 and the hurdle rate is 10% (NAV = $110).

Hard hurdle calculation is:  ($120 - 110) x 20% = $2.
Soft hurdle calculation is:  ($120 - 100) x 20% = $4.

During the latest credit crisis, there was some talk of having clawback provisions for hedge funds, just like in private equity.  A clawback allows investors to recoup prior years' incentive fees if a fund underperforms.  I have not seen much news on this front in 2010.

Mutual Fund to Hedge Fund Move

Mark Mobius, Chairman of Franklin Templeton's Emerging Markets Group, is rumored to be opening a hedge fund in Asia.  He manages the Templeton Asian Growth Fund which has returned 500% over the last ten years.  It is the second best performing Asian fund in that timeframe.  He has managed emerging markets funds since 1987.

After all this time, why would Mobius be moving from managing a mutual fund to a hedge fund?  The freedom and fees.  The fund will be able to short securities and use leverage to enhance returns.  Hedge funds can charge a 2% management fee plus 20% of performance fee.  Mutual funds charge a management fee and no performance fee.  The "2 and 20" fees allows managers to participate in the upside of the fund and gives them a floor on the downside.  We will examine this in a later posting.

The Reuters article can be found here.

2010 Annual Report: Hedge Fund Returns

Dow Jones Credit Suisse Hedge Fund Index had a return of 10.95% in 2010.  The index is composed of more than 8,000 funds.  The Global Macro strategy led the way with a 13.47% performance.  Other strategies that did well were:  Event Driven, Fixed Income Arbitrage and Managed Futures.  Details may be found here.

You can find an interesting side note here.  The Dow Jones Industrial Average outperformed the hedge funds with a return of 14.06%.

Recent Articles on Manager Selection

I was alerted to two articles at http://www.finalternatives.com regarding manager selection.  The first article contained the results from SEI, "a leading global provider of asset management, investment processing and investment operations solutions for institutional and personal wealth management",  (Source:  http://www.seic.com/enUS/about.htm) and Greenwich Associates.  Of 111 investors asked, 54% planned to increase their asset allocation into hedge funds.  The top two criteria were investment process transparency and risk management abilities of the firm.  The article can be accessed here.

The second article is an interview with Hal Daughdrill, Chairman of Diversified Trust Company.  This is repetitive  but the most important factors for selecting a manager are people, process (for stock selection and portfolio management) and structure (how much the manager has invested in the fund, liquidity, fund lockup provisions, etc.).  He also mentions that not being located in New York can be an advantage.  The article can be found here.

Creating a Hedge Fund Portfolio

Earlier, I had written some articles regarding how investment advisors and consultants pick the best mutual fund managers for their portfolio.  Let us return to hedge funds and discuss how fund of hedge funds do the same.  Again, I will rely on presentations from NYSSA's Fourth and Fifth Annual Manager Search and Selection Conferences.  I have combined details from three experts over the two conferences.  They are:

• Ben Appen, CFA - founding partner at Magnitude Capital (Fourth)
• Jeff Moses, CFA - Lyrical Partners (Fifth)
• Robert Teeter - Ten-Sixty Asset Management (Fifth)

Magnitude Capital uses experienced hedge fund professionals to source investments.  The team includes senior employees from UBS, Deutsche Bank and D.E. Shaw who have extensive contact lists.  They use a six step process to make investment decisions:

1. Risk Management:  In addition to accounting for the common risks (i.e. credit, liquidity, etc.), Ben considers crisis risk management.  The credit crisis of 2008 saw a rapid decrease of available borrowing, illiquidity in certain products and cross asset selling.  Rob also asks if liquidity is needed for the whole or just part of the portfolio.
2. Strategy Analysis:  Ben and Rob invest in different strategies based on market conditions.  Jeff focuses on buying long/short managers at a discount to the Net Asset Value of the fund.
3. Sourcing:  Networking, hedge fund service providers, databases and conferences are used to find managers.  Rob noted that there was greater institutional demand for the largest hedge funds.
4. Evaluation and Due Diligence:  Both quantitative and qualitative methods are used.  In the former case, past returns, correlation of these returns with other investments and how they affect the current portfolio are analyzed.  The latter method includes meeting with managers, reference and background checks, reviewing the fund's operations, auditing financial statements and general administrative review.
5. Portfolio Construction:  Ben's firm has a proprietary "optimizer" to help make investment decisions.  It ranks the incremental value of each manager.  This rank plus the investment team's judgment creates the portfolio.
6. Monitoring:  Ben tracks market conditions, portfolios (using monthly risk reports) and managers (weekly estimates, monthly risk reports, quarterly meetings and quantitative analysis).  Jeff wants to have broad conversational openness with managers in addition to receiving detailed portfolio holdings.  Rob said that transparency was increasing but wondered if people were taking advantage of the situation.  He noted that knowing the holdings in a portfolio does not make people aware of all the risks.

If you would like to read more advanced articles that are thoughtful and insightful, please go to Hedge Fund Portfolio blog.

Choosing the Best Fund Managers - Part III

Continuing on the manager selection topic, there was another presentation by Richard Schaffer, CFA, of Chartwell Consulting LLC and Nathan Sonnenberg, CFA, CAIA, of Fortigent.  Both firms provide investment advice to family offices, endowments and foundations and high net worth investors.  A slice of the buy-side commonly referred to as private wealth / mini-institutional investors.  The process is similar to the institutional side discussed earlier.  Both firms are looking to construct a portfolio of managers that will provide the best returns with low volatility.  I will highlight the differences:

• Additional attributes of managers
• Success in a variety of market cycles
• Reasonable fees
• Tax efficient
• Manager introduction for private wealth is done through networking and industry conferences
• Close monitoring of trades for separate managed accounts

Schaffer is the Director of Research / Senior Partner at Chartwell where one of his duties is investment manager search and selection.  Sonnenberg is a Managing Director in charge of asset allocation and risk management.  He oversees equity manager search and selection.  

Choosing the Best Fund Managers - Part II

Let's continue David Judice's concepts on selecting funds for investors from the Fourth Annual Manager Search and Selection Conference hosted by NYSSA.  In the first article, we concentrated on picking the best investments and listed the factors analyzed.  Now, let's review the reasons for removing an investment from a mutual fund.  They may originate from the investor or manager side.

From the investor:

• Re-balancing portfolio
• Change in market conditions cause a change in tactical asset allocation
• Change in investment policy statement (i.e. investor's goals or risk tolerance)
• Opportunity cost (Is there a better investment to fit investor's goals?)

From the manager:

• Unexplainable and poor returns.  Every manager will have three year periods of underperformance.
• Returns,  high or low, that do not fit expectations.  This may mean the manager, investment process or risk profile of the fund has changed.
• Key investment personnel leaving
• Firm is giving less transparency, access or client service
• An unprecedented, large loss
• Having liquidity or capacity (i.e. fund has too much assets under management) issues
• Trading execution issues
• Taking on too many investment styles

The manager selection process usually results in buying market indices plus 1-2 active managers to outperform the benchmarks.

Many thanks to David, Citi and NYSSA.  This was a fantastic presentation.

Choosing the Best Fund Managers - Part I

At the Fourth Annual Manager Search and Selection Conference in May 2009 hosted by the New York Society of Security Analysts (NYSSA), the most impressive presentation of the event was given by David Judice, a Managing Director who is the Director of Traditional Strategies Research at Citi.  His team researches over 1,000 products (mutual funds, ETFs and separately managed accounts) for Global Wealth Management to help investors make proper investment decisions.

According to a chart from Dalbar: Quantitative Analysis of Investment Behavior (www.qaib.com), the average equity investor's annual return lags the S&P 500 Index by 7.5% annually from 1988-2007.  During the same period, the average fixed income investor's annual return is 6% less than the Lehman Aggregate Bond Index.  There are many factors that cause investors to underperform the indices:

• Too many mutual fund choices
• Chasing "hot" managers that have strong returns over the past 3 years
• Limited time for detailed analysis
• Current market conditions are not included when researching funds
• Changing fund managers at the wrong time
• Equating strong returns with good investing skills
• Mixing emotions into investment decisions

To create a portfolio of the best fund managers, Judice's team uses a 5 step process.  The investor sets objectives for desired returns, risk tolerance and time horizon.  Once that is known, the team reviews the market conditions for the best tactical and strategic asset allocations for the investor.  Manager research is done using qualitative and quantitative analysis to identify the "best of breed".  Then the team helps allocate capital to the different managers that fit the investor's needs.  The portfolio is monitored on an ongoing basis to maintain its suitability for the client.  The process is refreshed as an investor's objectives may change.

Strategic asset allocation considers long term goals and risk aversion.  Tactical asset allocation maximizes returns based on current market conditions.  Proprietary research is used to find investments that will have extra returns over the intermediate term (1-3 years) by identifying the best managers and investing styles.  For example, the relative value strategy outperforms prior to or during recessions.

When researching a manager, his team looks at the following factors:

• Personnel and Firm - Credentials and expertise of key professionals, ownership structure of the fund, how key professionals are compensated, any turnover, experience and success of the firm
• Investment Process - Investment idea generation, portfolio construction methodology, sector/industry concentration, any volatility guidelines, investment style consistency, performance
• Research - Depth of research analysts; industry expertise; databases, technology and analytical tools; number of companies covered
• Operations - Assets under management, growth or stable personnel, legal or regulatory issues, when the firm closes funds to new investors

Research has proven that there is some persistence in fund managers.  The managers in the top 25% tend to stay there.  Managers in the ninth and tenth deciles are 2.5 times more likely to disappear.

Will US Stocks Be Popular Again?

I came across an article from last week at www.hedgeworld.com that asked if the retail investors were investing in stocks?  Last year, they pulled out $81 billion from stock funds and added $254 billion into bond funds.  What caused many investors to reduce their equity allocation was the banking crisis of 2008, the resulting recession and the May 2010 "flash crash".  You can find the article here.

ADRs & GDRs: How to Access a Foreign Market

In a prior article about mutual funds, the investment strategy in the prospectus defines the universe of securities for the fund manager i.e. small cap growth stocks in the US.  Some companies cross list their stocks on secondary markets to access investors from another country.  In the example above, a non-US company would create American Depository Receipts (ADRs) and the fund manager could invest in it.

ADRs are administered by a depository bank.  Most of them are handled by BNY Mellon, JP Morgan, Citi, Deutsche Bank and ComputerShare Trust Company.  According to their website, BNY Mellon holds a 64% market share in ADRs.  The foreign company would deposit X amount of shares into the bank who then issues a ADRs.  This new security can represent any number of shares.  The only guideline is that the ADRs should be at least $10.  This is because some investors do not buy stocks under that price.

There are three levels of programs for ADRs:  Level I - OTC, Level II - Listed and Level III - Offering.  Level I is the least restrictive.  All the company has to do is be listed on a foreign exchange and publish an annual report in English using its home country's accounting rules.  But it can only be traded over the counter.  Achieving Level II allows the company to be traded over an exchange (NYSE and NASDAQ).  The company has to register with the SEC, file an annual report using US accounting rules and meet the exhange's listing requirements.  Level III is the highest and allows the company to raise capital by issuing shares.  It has Level II responsibilities plus file concurrent documentation in the primary and secondary countries and file an Offering Prospectus when issuing shares.

If the depository receipt is in any other country, it is called a Global Depository Receipt.

For hedge fund managers, this could be a simple relative value arbitrage trade where they compare the values of the securities in the primary and secondary markets by buying the undervalued security and shorting the overvalued security.  They would exit the positions once the two securities' prices were in equilibrium.

The John Paulson Watch

John Paulson rose to prominence in 2007 when his hedge fund was up 164% on his now famous short on the US housing market.  He followed up with a 38% gain in 2008.  In 2010, a great fourth quarter gave Paulson a positive year.  His returns were 17%, 11%, 24%, 20% and 35% for his Advantage Plus, Advantage, Recovery, Credit and Gold funds.  The average return for investors was 7.1%, after paying out fees.  Paulson's funds were down at the end of September before rallying for above average returns by year end.   The articles are from the New York Times and Reuters.

Getting Out of a Hedge Fund Investment

A mutual fund investor can sell his shares in a day.  This is because the manager can raise enough capital to redeem the investor by selling stocks or bonds.  They are traded every day at public prices.  Hedge funds may invest in assets that cannot be sold quickly.  To avoid forced selling that would result in a large loss, they add a lockup period to the investment contract.  During this period which may be anywhere from three months to two years, the investor cannot redeem any shares.  The investor can get out of his hedge fund investment by finding a buyer.  Oftentimes, they will turn to a third party, such as a bank or a market provider (such as HedgeBay), to source a transaction allowing the selling investor to retrieve capital and reduce their risk.  The buying investor gets to invest at a low price, a break on manager fees due to "high water marks" (we will explain this later.) and access to a "closed" manager i.e. a manager who is not accepting any more investments.

In May 2009, I attended the 4th Annual Manager Search and Selection Conference at the offices of the New York Society of Security Analysts.  One of the presentations was Growth and Trends for the Secondary Market for Alternative Investments.  Nigel Dawn of UBS and John Roglieri of HedgeBay gave us their views on the Private Equity and Hedge Fund markets.  We will concentrate on what John said and leave Private Equity for another article.  John was the co-head of US secondary market hedge fund transactions.  He worked with investors to find investment opportunities and liquidity for hedge fund positions.  At that time, HedgeBay had completed $1 billion USD in transactions; an estimated 50% market share.  The size of the trades were from $1-100 million USD.  The average discount was 18%.  This means an investment worth $100 could be bought for $82.

Fast forward to December 2010, the discount for October 2010 had finally risen back to 19%; almost par with May 2009.  It retreated in November to 26% due to the ongoing expert network probe by the FBI.  Seeing as no one knows who will be the next fund implicated, some investor are reducing their risk by selling out of any positions and to clean their portfolio of losing investments for 2011.  The links to the articles are Albourne Village and Hedgeco.net.

Illiquidity Risk

I saw an article in the CAIA newsletter this month regarding Asset Allocation and Illiquidity Risk by Hossein Khazemi, Program Director.  Compared to previous posts, this is a slightly advanced idea.  Khazemi writes:
"Liquidity represents the ability of an entity to fund future investment opportunities and to meet obligations as they come due, without incurring unacceptable losses. If there are mismatches between the maturity of an entity's assets and liabilities, the entity is exposed to illiquidity risk."  He writes later about the Yale model of asset allocation created by David Swensen.  Swensen has written Unconventional Success:  A Fundamental Approach to Personal Investment and Pioneering Portfolio Management:  An Unconventional Approach to Institutional Investment.

The article can be accessed here.

Happy New Year to everyone!  Best wishes for a great 2011.