Absolute Return Funds and Institutional Investors

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Absolute Return Funds and Institutional Investors
abcd

• Robert Howie
• 23 June 2003
• The Caledonian Hilton Hotel, Edinburgh

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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

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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

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Hedge Fund Strategies Currently Utilised
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Hedge Fund Strategies Likely to be Utilised in
Future
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Restrictions Preventing Hedge Fund Investments
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Attractive Attributes of Hedge Funds
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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

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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

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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

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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

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Heterogeneity of hedge funds
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Regression Analysis of Hedge Fund Index Returns -
Factors

• Equity prices (SP 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)

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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 (gt0.6)
• 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

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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

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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

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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

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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?