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.