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Alternative Investments - December 15, 2005

Interview with Lionel Martellini, Scientific Director of the Edhec Risk & Asset Management Research Centre

In this month's interview, Professor Lionel Martellini, PhD, the scientific director of the EDHEC Risk and Asset Management Research Centre, discusses a recent research paper entitled "Investing in Hedge Funds: Adding Value through Active Style Allocation Decisions" and all of the centre's research programmes in the area of hedge funds. Lionel is a member of the editorial board of the Journal of Portfolio Management and the Journal of Alternative Investments. His expertise is in derivatives valuation and optimal portfolio strategies, and his research has been published in leading academic and practitioner journals. He has also co-authored several books in the area of fixed-income securities and alternative investment strategies.

Lionel Martellini

In the most recent Edhec research paper "Investing in Hedge Funds: Adding Value through Active Style Allocation Decisions", you find that significant value can be added to a hedge fund portfolio by implementing active style allocation decisions at both the strategic and tactical levels. Could you tell us briefly how this is done?

Lionel Martellini: The bulk of the message conveyed in the paper is straightforward and has important potential implications for the hedge fund industry: it is only by taking into account the exact nature and composition of an investor’s existing portfolio, as opposed to regarding hedge fund investing from a stand-alone approach, that institutional investors can truly customise and maximise the benefits they can expect from investing in these modern forms of alternative investment strategies.

Overall the results in this paper strongly suggest that significant value can be added in a hedge fund portfolio through the systematic implementation of active style allocation decisions, both at the strategic and tactical levels. While this fact has long been recognised by market participants, the lack of reliable asset allocation tools has not facilitated the implementation of effective top-down approaches to investment in hedge funds.

In this study, we argue that such techniques are actually already available and we argue that a suitable extension to the Black-Litterman model naturally allows for the incorporation of active views about hedge fund strategy performance in the presence of non-trivial preferences about higher moments of hedge fund return distributions. This model can be used to implement active views on hedge fund style performance in a meaningful and consistent approach that avoids the pitfalls of standard optimisation procedures.

In the past year, Edhec has produced a number of research papers on hedge funds under your responsibility as scientific director, including papers on the determinants of the performance of funds of hedge funds, the packaging of alpha, hedge funds in asset-liability management, and more. What are the main findings of these papers?

Lionel Martellini: The main finding of this line of research has been to emphasise that hedge funds offer not only alpha but also beta benefits, which is consistent with a modern investment process that separates management of alphas and betas by organising the portfolio into a core (i.e., beta management) and a satellite (i.e., alpha management).

What our research has shown is that, because of their alpha and beta benefits, hedge funds find their place in both the core and the satellite of investors' portfolios. This stands in sharp contrast with current industry practice where the focus is still mostly on considering hedge funds as mere candidates for satellites.

Most of our research has actually focused on the design of the core portfolio. In particular, we have introduced an approach that relies on the concept of optimal diversification and have shown that certain hedge fund strategies can serve as risk reducers. This has allowed us to present a methodology that aims to design optimal diversification benchmarks made up of these strategies, with benefits that can be dramatic when considered both from a pure asset management perspective and from an asset-liability management perspective.

We believe that these academic results are consistent with what is likely to be a profound trend in the alternative industry in the years to come, which involves progressively switching from an alpha logic (focus on outperformance and abnormal returns) to a beta logic (focus on risk management and exposure to rewarded risk factors).

There is a lot of talk at the moment about hedge fund diversification. How does one go about measuring alternative diversification?

Lionel Martellini: Since seminal work by Markowitz (1952), it is well-known that diversification potential can be measured in terms of reduction of the volatility of a portfolio that follows from the introduction of a weakly correlated asset or asset class, i.e., an asset or asset class that has a beta with respect to the initial portfolio that is lower than one. Using volatility as a measure of portfolio risk is, however, only valid under the restrictive assumption that asset returns are normally distributed, an assumption that cannot be taken for granted with hedge funds. This outlines the need for looking beyond the first and second order moments of alternative fund return distributions, i.e., their mean and variance, when trying to measure diversification potential.

Our research has actually shown that there are higher-order generalisations of the concept of beta that can also be used as complementary measures of diversification potential. Just as standard beta coefficients indicate the extent to which an asset may generate second order moment (i.e., volatility) diversification effects when introduced in an existing portfolio, 3rd order and 4th order betas indicate the extent to which an asset may produce third and fourth order moment (i.e., skewness and kurtosis) diversification effects when mixed. Hence, a low or negative second, third, and fourth moment beta indicates good diversification potential, in the sense of a potential for a decrease in the overall portfolio’s average risk (i.e., volatility), in the bias toward lower-than-average returns (i.e., skewness), and in fat-tails (i.e., kurtosis), respectively.

In broad terms, how does the research centre choose the hedge fund research programmes that it carries out?

Lionel Martellini: When looking into a new research programme, our centre aims to find the right combination of two elements, one being practical relevance, the other being academic rigor. It is only if a topic under consideration fits these two criteria that it is eventually pursued.

Broadly speaking, our goal and our ambition are to have an impact on the way the asset management industry operates. There is so much that is written in academic journals that has absolutely no relevance to the industry; on the other hand, there is so much that is done in practice that cannot be justified from an academic standpoint. We believe that this situation involves a significant opportunity cost. Helping bridge the gap between the industry and practice can be regarded as our raison d’être.

To ensure that our research meets the highest standards of academic research, we systematically benchmark its outputs by submitting our papers to international scholarly journals. The positions some of our members hold on the editorial boards of some of those journals also help us to make sure that we closely follow the most recent advances in academic research. We also greatly benefit from feedback and perspective emanating from various colleagues and co-authors at prestigious academic institutions such as Caltech, Princeton University or Yale, with whom we are in close relationship.

Ensuring that our research also scores high in terms of practical relevance is perhaps more subtle. Ex-ante, we test it from financial support that our research centre is receiving from various prominent players in the asset management industry. We believe that the willingness of a sponsor to have its name attached to an academic research paper is a reasonable sign of the perceived interest by the market of the research. Ex-post, we test this through the success of the yearly conferences that our research centre holds in various European cities (Geneva, London, Paris).

As far as future projects are concerned, what are you currently working on and what areas are you going to be exploring in the coming months?

Lionel Martellini: The most significant research programme started recently is one dedicated to asset-liability management.

Recent difficulties have drawn attention to the risk management practices of institutional investors in general and defined benefit pension plans in particular. That institutional investors in general, and pension funds in particular, have been so dramatically affected by recent market downturns can be taken as an indication that asset allocation strategies implemented in practice may not be consistent with a sound liability risk management process.

We have produced various research papers aiming at improving the understanding of asset allocation decisions from an asset-liability perspective. Topics of particular interest are the analysis of an integrated pension plan problem, where contribution and borrowing decisions from the sponsor company are taken into account. Other topics of interest are the integration of hedge funds in institutional investors’ portfolios, as well as the design of optimal dynamic asset allocation strategies in the presence of liability constraints.

We believe that these academic perspective insights can have important potential implications in the context of the current pension fund crisis.