Peter J. de Marigny
is Portfolio Manager of DITMo® Strategies, an Equity Hedge, Aggressive-Income Objective, Buy/Write Portfolio for an Aggressive-Income Objective used as an Enhanced Cash investment vehicle. Pj is also Head of Risk Alternative Strategies for Newport Beach, CA advisor Renovatio Asset Management.
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Jesse Marrus
Jesse Marrus is the Founder and CEO of StreetID, a financial career matchmaking, news and networking site. He has unique insight into the financial services job industry including career advice, employment trends, fund formations, layoffs and hiring developments.
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Rashida Fleet is involved with consulting and working with managers during the fund launch phase. Her work includes; interviewing managers, collecting information for the HedgeCo database and contributing to the HedgeCo News feed.
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Tim Seymour is co-founder and managing partner of Red Star Asset Management, as well as Chief Operating Officer of the $116 million Red Star Double Alpha Fund. » View Tim Seymour
Richard Heller Richard Heller is a partner at the New York City law firm of Thompson Hine LLP. His experience is in the formation of private offerings for hedge funds as well as the formation of registered broker-dealers and RIAs.
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Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and President of Alpha Theory™, a Portfolio Management Platform designed to give fundamental money managers the ability to create their own repeatable discipline to organize the complex process of portfolio management.
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Carbon360 has published the results of a survey they conducted over the past month entitled Capital Introduction Trends in 2010. Daniel Golyanov authored the report and asked for industry professionals to provide thoughts on future of the industry including which strategies would be popular in the near term future, where investors are based, and the evolution of the industry in the next five years.
HedgeCo’s managing partner, Evan Rapoport added his own thoughts that were used as an opening quote:
As the hedge fund industry stabilizes, we expect investors to become more active. 2010 should be a prosperous year for alternative investments. The managers and investors who survived 2008 and 2009 are the cream of the crop, providing third party marketers and capital introduction firms with a vast array of opportunity. As hedge funds go, so goes the capital introduction industry.
In that mode of thought, transparency and risk management are the popular trends. I would expect new regulations to affect how third party marketers and capital introduction teams are able to conduct business. But this change is not to be feared, but rather embraced. If we can work with regulators to legitimize the industry and overcome the scandalous actions of a select few, I am all for it. This will be a major theme ongoing.
I expect institutional investors to be more receptive to newer managers, fee structures to remain stable, and foreign investors to invest more in the US and vice versa. Europe should lose market share to Asia, and new markets will open up as countries move from developing markets to developed markets. Proprietary trading and hedge funds owned by large US banks will most likely weaken or disappear under the current administration and, more importantly, current US economy sentiment, leading to opportunities for independent investment management companies. Overall, I expect 2010 to build on the strength of the latter half of 2009.
The most interesting conclusion on the industry, according to Golyanov, is that the majority of third party marketers work with new and emerging managers and that these are the very funds that are expected to see the majority of consolidation in order to compete with larger and established managers.
Evan Rapoport, founder and managing partner of HedgeCo Networks, is an expert on marketing hedge funds to investors. On his blog, he has been doing a series on using the internet to market hedge funds to investors.
In the first piece of the series, he discussed creating websites that draw investors in without stepping in to the area of generally soliciting clients. Basically, it’s important to have a website that is well put together and discusses the key aspects of the fund company and absolutely nothing about the actual hedge fund.
In the next article, he talks about the benefits of listing hedge funds on a hedge fund database. These hedge fund databases have access to thousands of accredited investors, and as such, your hedge fund can be viewed by many more potential clients at one time than anywhere else.
Over the next week, he is going to dole out advice on using blogs and social networking sites to increase visibility and making your new visibility effective as a marketing tool.
Lost in the shuffle of the recent economic crisis, American financial institutions now have the opportunity to service clients of their now-failed counterparts. No where has this been more evident than the world of hedge fund prime brokerage. When Lehman Brothers and Bear Stearns failed, the rest of the banking industry went into defense mode and began to cut servicing to riskier or less profitable hedge fund clientèle. Hedge funds were losing money anyway, and prime brokerage departments couldn’t fathom spending time, effort, or money to service these smaller, less-conspicuous hedge funds.
Now, hedge funds are roaring back, and many new prime brokerage departments are opening to take advantage of the availability of new or formerly-undesirable prime brokerage clients. According to Jenny Strasburg of the Wall Street Journal, FBR Capital Markets and Cantor Fitzgerald &Co. have both added prime brokerage units in the past few months. Conifer Securities began servicing prime brokerage clients in January, Merlin Securities opened its prime brokerage department in 2004, and Jeffries & Co. launched prime brokerage in 2007.
While these new prime brokerage departments are operating in relative obscurity, they are doing big business with hedge funds with less than $500 million in AUM. In 2007, analyst estimated the prime brokerage market to be worth more than $10 billion, and these new firms are poised to take in clients that can’t find servicing from the major brokerage houses like Goldman Sachs, Morgan Stanley, and JP Morgan. At the end of the day, Wall Street is an eat-what-you-kill industry, and the big boys are leaving a lot more than scraps for the smaller brokerage houses to fight over.
We received an interesting question from one of our members earlier this week:
“I was wondering if someone could give me an idea of where hedge funds are on the totem pole as far as risk with intangible investments. My guess is that they rank with growth mutual funds and are less risky than stocks but I would like a more descriptive census of where they stand amongst stocks and mutual funds.”
Hedge funds are uniquely difficult to assign risk profiles because they employ many different strategies. Some hedge funds buy up illiquid assets when liquidity is at a premium, and these assets are selling at pennies on the dollar. In some situations, the fundamentals are still very sound, but the hedge funds are purchasing the assets at a deep discount further lowering the risk and raising the potential return on investment. When done properly, this strategy is low risk and similar to a corporate bond fund. Other hedge funds will invest in highly speculative strategies, specializing in risky assets like distressed debt and emerging market equities, or risky derivatives like commodity futures. These strategies tend to have risk profiles similar to investing in individual stocks, but better managers will be able to reduce risk and stabilize returns to a degree.
To develop an accurate risk profile for a specific hedge fund, investors need to gather as much information about the underlying assets and fund strategy as possible. Usually, investors only have access to the types of assets used, but increased transparency in hedge funds is the current trend, and hedge fund managers will probably start disclosing more and more information about their trading positions. For each strategy, certain levels of risk are inherent, and remember that leverage increases risk just like returns. While strategy will tell investors a lot about the hedge fund’s risk profile, implementation of the strategy is another important piece to hedge fund risk.
Therefore, investors have to develop a risk profile of the hedge fund manager. This profile should include information about the manager’s historical performance for all his funds, including statistical analysis that measure standard deviations, maximum drawdowns, downside deviations, and all the risk-adjusted return ratios like Sharpe and Sortino ratios. Particular attention must be paid to the hedge fund manager’s performance in similar strategies to the fund of interest. Investors need to identify how the fund manager performed when using a “low risk” strategy or a “high risk” strategy.
Lastly, investors need to inspect the fund’s infrastructure. Check to make sure the hedge fund is using high quality third party administration, legal advice, auditing services, and brokerage services. Performing due diligence on a fund’s infrastructure goes a long way towards identifying counter party risk and preventing fraud
I’m pretty sure my answer to the above question is a little more technical and in depth than what was asked for, but the point is that hedge funds can’t be fitted to neat little risk profiles or mutual fund style boxes. However, hedge funds were originally designed with the intention of preserving capital for the ultra-wealthy. Because the hedge fund manager ultimately has control of the fund and can utilize in style he deems appropriate, he is the key differentiator in measuring risks of hedge funds and risks of other investment vehicles. So, my short answer is hedge funds are as risky as the hedge fund manager wants them to be.
HedgeFund Intelligence’s Press Release from today states that the fund of funds industry shrank by $95 billion in the first half of 2009 but still manages $735 billion.This represents a decline of 11.4 percent in assets under management (AUM).Firms with more than $1 billion in AUM manage a combined $613 billion.According to HedgeFund Intelligence, 18 fund of hedge funds companies have been removed from the InvestHedge Billion Dollar Club (list of firms with $1 billion or more in AUM).Recently, we listed the top 50 fund of hedge funds firms and found that the top 50 firms manage $489 billion.
While the fund of hedge fund industry has shrank over the past year, investors are looking at the decline as a culling of the herd.The better funds of funds have survived the economic turmoil and are ready to take on new investors and identify promising hedge funds.
Many economic analysts and pundits don’t believe we are going to see prolonged aggressive bull financial markets going forward.Rather, investors will be dealing with volatile conditions and unstable markets domestically and abroad.The superior fund of funds managers will have to shrewdly identify hedge fund managers using strategies that capture positive returns while reducing downside deviations in volatile markets.
Furthermore, fund of hedge fund managers will have to be judiciously observant of the infrastructure of fund managers to avoid fraudulent situations that have recently plagued the hedge fund industry and avoid the Bernie Madoff’s of the world. Perhaps, the steady fund of hedge funds managers can be the stabilizing force that returns respectability to the hedge fund industry.
By now, I think most people have heard about the ex-Goldman software programmer who was arrested in July for allegedly stealing some of Goldman’s high-frequency trading software code. I am not a criminologist or legal expert, nor am I a software expert that could tell you if accidentally sending small pieces of the code while sending other software to an outside server in Germany is a plausible defense. But, I do want to touch on one piece of the story.
No Bailout for Programmer
According to Alex Berenson of The New York Times, a federal prosecutor asked that Sergey Aleynikov, the ex-Goldman programmer, be held without bond because the software could be used to “unfairly manipulate” stock prices. It took me a little while to understand why I kept coming back to that sentence, until it struck me that a federal prosecutor was asking for a man to be detained without bail for being such a dangerous force to society by having Goldman’s proprietary high-frequency trading program, or actually just a small piece of it (32 megabytes of the 1,224 megabyte code).
I want to mention that the prosecutor might have used the “potential” danger of possessing this code just to keep a man behind bars, which is the job of the prosecution. However, if the prosecutor believes that this program has the ability to upset financial markets and send society into economic upheval, why should Goldman have the right to manipulate the markets? Goldman Sachs has the platform and capital to take advantage of high-frequency trading, and quite simply, Sergey Aleynikov does not.
An Afterthought on High Frequency Trading
I want to say that I don’t particularly see a problem with brokerage firms using high-frequency trading programs. For years and years, floor traders have been using strategies to squeeze out some extra money on bid-ask spreads and getting in ahead of orders for large blocks. Electronic trading has squeezed the profitability of capitalizing on bid-ask spreads, and trade orders come in so fast now that no human would be able to keep up. High-frequency trading programs allows trading firms to use their old world strategies with new world technologies to make money in the modern day exchanges.
Furthermore, I would suggest that high-frequency trading is not the danger that the federal prosecutors make it out to be. If a programmer steals software from his old employer, he is a criminal, but is he a criminal mastermind capable of causing damage to the financial markets that would warrant holding him in jail during his trial to protect society? I mean, the strategy is profitable, but if the big investment banks were capable of manipulating the markets with software, why would the Goldman’s and JP Morgan’s of the world need a bailout in 2008?
I recently wrote an article on the emerging markets across the globe, and looking at the charts of performance for each country, I couldn’t help but notice one thing. While magnitude of volatility varied from country to country, every chart had the same shape. Every trend line moved together. MSCI Barra provides charts of the individual emerging markets based on the listed equities of each country. Each emerging market was booming up until 2008, took a sharp decline in the middle and end of 2008, and bounced back at the beginning and middle of 2009, which probably isn’t surprising to anyone reading this. “Some of emerging markets hedge funds were down almost 50 percent,” according to Andrew Schneider, managing partner of HedgeCo Networks. “Take the Tarpon All Equities Fund for example. They lost 43 percent in 2008.” While this type of volatility is expected in the emerging markets universe, fund managers and investors don’t have to withstand these massive losses to access the spectacular gains of better years.
The Emerging Markets Market
Because each country’s equity market moved in such a similar pattern, I began to think we could start looking at the whole basket of emerging markets as a unique market, like the US equities market. The broad movements imply market or systematic risk. When the emerging markets market (EM market) moves, individual emerging markets face pressure to move in the same pattern.
The movements of the emerging markets as a whole are mainly due to foreign investors’ capital moving into and out of the EM market based on the perception of emerging countries in general or as emerging market investors’ capital is fluctuating, which was the case in 2008. Investors in developed countries lost money domestically and liquidated their foreign holdings. These types of fluctuations are artificial, since a country’s economy does not become less productive and innovative just because foreign investors are pulling out capital. I would equate these artificial movements to a stock that loses ten percent market value when it misses its earnings forecast by a penny.
Reuters reports British pension funds are joining the battle against European Union’s proposed regulations on the hedge fund and alternative investment universe. The National Association of Pension Funds (NAPF) and a director at Hermes, manager of the largest corporate scheme in Britain, said the rules could restrict investment choices and returns, further affecting the ability of pension funds to provide ample returns to support the aging population.
The current draft of legislation would require hedge funds to register and disclose leverage levels, according to Reuters. Furthermore, non-EU managers would be restricted in sales of funds in Europe. The Alternative Investment Management Association (AIMA) estimates could create a 25 billion euro hit for European pension funds and as much as 2.5% decrease in returns. We are seeing attempts at regulating the hedge fund industry across the globe with proposed legislation by the US Treasury. Hedge funds have successfully lobbied to keep these types of regulations from affecting the industry in the past, but mounting pressure from legislators and their constituents is on the rise due to failures of funds and fraudulent fund managers in recent years.
Investors would benefit from registration of funds requiring leverage ratios and returns to be disclosed along with risk statistics. As failures and fraudulent managers gain media attention, look for proposed regulations to gain traction with legislatures.
Philippa Aylmer, contributing editor to The Hedge Fund Journal, writes, “If the last decade could be described as the biggest credit party ever, then the end of 2008 brought the mother of all hangovers. The hedge fund industry took a beating along with much else in the financial services sector and funds of hedge funds felt their share of the pain.”
The Hedge Fund Journal‘s report of the “Global 50: Funds of Hedge Funds” shows the decrease in assets under management in funds of hedge funds from September of 2008 to June 2009. With the market downturn and the uncovering of Madoff’s $50 Billion ponzi scheme, funds of hedge funds had been hemorrhaging AUM in 2008 but have slowed the bleeding in the early part of 2009. Will the fund of hedge funds recover from their wounds by the end of this year, or will it take more time? We will have to wait and see.
Here are the top 50 fund of hedge funds groups ranked by assets under management as of the end of June in 2009.
The market downturn last year has led mutual funds to begin testing new strategies to produce gains with lower risk. Many managers are trying to replicate the methods used by long/short hedge fund managers. By finding negatively correlated positions, fund managers are able to offset losses with gains from other assets in the portfolio.
“130/30” Funds
“130/30” funds short securities valued at 30% of the value of the assets in the fund, and can use the proceeds to purchase long positions in other securities, allowing the fund to invest 130% of the fund’s value in a long position. For instance, if the fund manager believes Visa is a superior stock to Mastercard and has a $1,000,000 fund, he could short Mastercard for $300,000 and use that $300,000 plus the $1,000,000 he has in the fund to buy $1,300,000 in Visa stock. Now the fund manager has a net $1,000,000 long position because he is holding $1,300,000 in a long position and $300,000 in a short position.
If the assumption about Visa outperforming Mastercard is correct, and the market is up, The gain on the extra $300,000 in the long position is higher than the loss on $300,000 short position. If the market is down, the gain on the $300,000 short position will be higher than the extra $300,000 in the long position and offset some of the loss on the whole long position.
Market Neutral Long Short Funds
A long/short fund can be similar to market neutral funds if the size of the investments in the long position equal the short position investments. For example, if a long/short fund manager believes that Coca Cola is a better stock than Pepsi Cola and puts $1,000,000 into a long position on Coke and sells another $1,000,000 in a short position on Pepsi, he has taken a market neutral position because he has net zero position.
Downside to Long/Short Strategies
The purpose of a long/short fund is to create stable returns, but there is a downside. In the Visa/Mastercard example above, the long/short fund doesn’t make nearly the amount of gains as a long position during an aggressive bull market. Also, the profitability of a long/short fund is predicated on picking one investment to outperform the other. Like market neutral funds, there is the unique risk in long/short positions called “beta mismatch”. If the beta of the long position is larger than the short position, a market downturn should cause the long position to lose more, as market moves affect the long position more. Furthermore, if the beta of the short position is larger, a market upswing should increase the short position’s loss more than the long position’s gain.
Paired Trades
While long/short funds can be used to decrease market risk, fund managers can reduce other types of risks by making “paired trades”. Using the Coke/Pepsi example from above, the fund was protected whether the market moved up or down. Also, the fund was protected even if the soda industry moved up and down. By using this “paired trade” model, fund managers can hedge against market swings in particular sectors, industries, regions, and currencies.
In that mode of thought, transparency and risk management are the popular trends. I would expect new regulations to affect how third party marketers and capital introduction teams are able to conduct business. But this change is not to be feared, but rather embraced. If we can work with regulators to legitimize the industry and overcome the scandalous actions of a select few, I am all for it. This will be a major theme ongoing.
The current draft of legislation would require hedge funds to register and disclose leverage levels, according to 
