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Alternative Investments - May 17, 2006

Interview with François-Serge Lhabitant, Head of Research at Kedge Capital and an associate professor of finance at EDHEC Business School

François-Serge Lhabitant, PhD, is Head of Research at Kedge Capital and an associate professor of finance at EDHEC Business School. He also sits on the EDHEC Risk and Asset Management Research Centre’s International Advisory Board. In this interview, he discusses the benefits of hedge funds for institutional investors and the latest alternative investment techniques. He also talks about the Lhabitant Martellini Advanced Hedge Fund Investing seminar, which will be held at the Savoy in London on June 22-23.

François-Serge Lhabitant

Without giving away the contents of your upcoming seminar, what are the general benefits of hedge fund investing for institutional investors? Do hedge funds really have a role to play in Asset-Liability Management?

François-Serge Lhabitant: Institutional investors can get numerous benefits if they approach hedge funds with a risk budgeting perspective rather than with a pure dollar allocation perspective. These benefits include better diversification, better downside risk management, and better risk-adjusted performance. Fortunately, many institutions have realized that traditional asset management and its buy and hold approach was essentially synonymous with unmanaged risk exposures and serious losses in a bear market. Now, they want to access risk controlled portfolios, which hedge fund managers can easily provide - they come from proprietary trading environments, where risk management techniques are a prerequisite to survive.

Regarding ALM, I think that hedge funds have a key role to play, particularly when considering surplus preservation and optimisation, but only if they are perceived as a complement to existing asset classes rather than as a segregated asset class. After all, hedge funds are investing in stocks and bonds, so why should they form a separate category? The fact that they manage these assets differently does not qualify them as a new asset class. So, when analysing hedge funds in an ALM framework, it is essential to use them for what they are: a different investment style in traditional assets.

What in your view are the best investment supports or vehicles for hedge funds and how has this area evolved over the past five years?

François-Serge Lhabitant: It really depends on what you are looking for. From a European perspective, I would say that onshore hedge funds still have a long way to go to be competitive with offshore hedge funds. They require a deeper due diligence and are not very liquid, but this is the cost to pay if one wants to access the hedge fund industry. For people that want to trade hedge funds on a weekly basis, managed accounts are growing, but they are limited in terms of strategies and the best hedge fund managers are not willing to offer them. In addition, managed accounts are not a guarantee against risk, as illustrated by the blow up of Beacon Hill (which had several managed accounts) and the recent bankruptcy of the managed account platform PlusFunds.

What are the latest techniques and approaches used in risk management and performance measurement that enable the conditions for investing in hedge funds to be improved?

François-Serge Lhabitant: When investing in hedge funds, one must remember that they are not basic securities. Hedge funds are diversified and dynamically managed portfolios of securities. It is therefore essential to use tools that can take into account their dynamic nature, their non linear relationship to traditional risk sources (e.g. equity, interest rates, credit, currencies, etc.) and their built-in diversification.

What does the future hold for hedge fund investing? What major developments are you expecting in the next few years?

François-Serge Lhabitant: The best hedge fund managers are always reinventing themselves and looking for new sources of profits. Today, I can see the most value added in the area that intersects private equity and hedge funds. Private equity funds have chosen to ignore medium-term deals, and most hedge funds are too liquid to consider them. This creates numerous opportunities. Another promising area is distressed securities, as several companies will not be able to survive if interest rates reach the 5% level.

In particular, what do you think of the approaches involving passive replication of hedge fund performances? Will they provide serious competition for funds of hedge funds and investable indices?

François-Serge Lhabitant: The passive replication of hedge fund returns is extremely appealing for benchmarking and performance analysis, but I do not think it constitutes a threat to hedge funds – at least in the current state of research. Most of the existing approaches can replicate the return distribution of a hedge fund over a given time horizon, and eventually its correlation with other asset classes (or its copulas). But (i) they do not replicate the dynamic behaviour of the hedge funds over time, and (ii) they still need to be tested out of sample. As an investor, I do not care only about a final payoff, I care about my wealth on a day to day basis.

Why did you set up the Advanced Hedge Fund Investing seminar with Professor Martellini? What original features does it have?

François-Serge Lhabitant: There are too many hedge fund seminars nowadays, but none of them seems to go beyond a simple qualitative description of basic hedge fund strategies. What Advanced Hedge Fund Investing aims at providing is a unique mix of theory and practice, as well as an introduction at what will be hedge fund portfolio management tomorrow … well, I should say already today for some of us.