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Alternative Investments - February 20, 2006

EDHEC European Alternative Diversification Practices Survey

The EDHEC European Alternative Diversification Practices Survey not only provides a detailed summary of the results of the survey but also of the research carried out by Edhec and by numerous professional and academic institutions on this topic. We have therefore grouped the conclusions drawn from the review of the literature and the results of the questionnaire that made up the EDHEC European Alternative Diversification Practices Survey into five themes:

  1. Introduction to Hedge Fund Strategies and their Risks
  2. Investment Ideology
  3. Implementing Alternative Diversification
  4. Hedge Funds in Asset/Liability Management
  5. Controlling Hedge Fund Risks in the Investment Process

Introduction to Hedge Fund Strategies and their Risks

The objective of the first part of the document is to familiarise the reader with hedge fund strategies. As a result of the considerable flexibility that fund managers enjoy in the alternative arena, hedge funds follow a myriad of heterogeneous strategies. As a consequence, most investors suffer from a certain lack of understanding of the return generating processes of the different strategies. We try to fill the gap and begin with a qualitative analysis of the most popular strategies in order to identify their returngenerating processes. We then carry out a quantitative analysis to gain a better understanding of the key return drivers of the different hedge fund strategies. As we shall see, hedge fund strategies are exposed to a multitude of risk factors, and these exposures are not only multiple but also time-varying and present option-like features.

We subsequently focus on another crucial dimension of risk in the alternative arena, i.e., operational risk. In particular, we point out that operational risks greatly exceed the risks related to the investment strategy and that for the vast majority of the most publicised hedge fund collapses in the last few years (i.e., funds that have ceased operations with or without returning capital to their shareholders), operational weaknesses were the root cause of the failure or had prevented a fund from managing a crisis situation appropriately in an unexpected financial context. We thus review the key operational risks ranging from compliance with the offering memorandum to pricing and valuation of hedge fund holdings and reconciliation with third parties, etc.

We finally analyse European institutional investors’ answers to our survey in order to find out how they perceive hedge fund strategies. We first observe that 51% of European institutional investors are already exposed to hedge fund strategies. These represent, on average, 7% of their global assets. We then observe that 60% of European institutional investors consider that they are well informed as to the nature of hedge fund risks. They appear to be well aware of the pros (e.g., decorrelation with traditional asset classes and/or economic cycles, low level of volatility and/or extreme risks, high level of alpha) and the cons (e.g., lack of transparency, high level of fees, low level of regulation, operational risks) of investing in hedge fund strategies. However, being aware of the risks is one thing; being capable of managing these risks is another. Indeed, only 29% of European institutional investors appear to be capable of carrying out a risk analysis independently from that provided by the fund manager and only 48% of them appear to be capable of integrating these risks in a global analysis of the risks of their assets.

Investment Ideology

The objective of the second part of the document is to emphasise the role that hedge fund strategies can play in traditional investors’ portfolios. To this end, we first highlight a profound trend in the alternative industry 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). In particular, we point out that hedge funds offer both alpha and beta benefits. This gives us the opportunity to introduce 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). As we shall see, because of their alpha and beta benefits, hedge funds find their place in both the core and the satellite of investors’ portfolios. We pay particular attention to the core portfolio and elaborate on beta management.

More specifically, we present two different approaches to capitalising on hedge fund betas. On the one hand, we introduce an approach that relies on the concept of optimal diversification. We see that certain hedge fund strategies can serve as risk reducers. We thus present a methodology that aims to design optimal diversification benchmarks made up of these strategies. On the other hand, we introduce an approach that relies on the concept of optimal substitution. We see that other hedge fund strategies can serve as return enhancers. We thus show in concrete terms how an equity-oriented investor can implement an optimal substitution strategy relying on these strategies. As we shall see, these two approaches, though diametrically opposed, yield similar results in that they both allow for a significant improvement in an investor’s riskadjusted performance. Furthermore, investable hedge fund indices appear in both cases to be natural candidates to serve as allocation tools in the portfolio construction process.

We finally analyse the answers given by European institutional investors to determine their perception of hedge fund investing. We first observe that 73% of European institutional investors manage an optimal mix of asset classes without distinguishing between passive and active products, which certainly explains why only 33% of European institutional investors have implemented a core/satellite approach to constructing their portfolio (many investors, incidentally, still appear to find this approach somewhat mysterious). We then find out that only 27% of European institutional investors associate the core portfolio with passive products, suggesting that the remaining 73% could potentially integrate hedge funds – which are by nature actively managed funds – in their core portfolio. As a consequence, even if most European institutional investors still naturally integrate hedge funds in their satellite portfolio and traditional asset classes in their core portfolio, it is highly probable that the switch from an alpha logic to a beta logic observed in the alternative arena will be followed by a transfer (at least a partial one) of hedge funds from the satellite to the core portfolio of European institutional investors. Indeed, 67% of European institutional investors already consider that hedge funds are diversification complements which are meant to improve the diversification of their portfolio; 8% of them even consider that hedge funds are an essential element of a well diversified core portfolio. All European institutional investors now have to decide whether hedge fund strategies are meant to diversify or to replace traditional asset classes. For 38% of them, the role that hedge fund strategies are supposed to play has not yet been clearly defined.

Implementing Alternative Diversification

The objective of the third part of the document is to show how investors can implement the investment ideology presented in the second section. In practical terms, when investors decide to gain exposure to hedge funds, they dispose of several options. They can invest in (i) single hedge funds, (ii) standard products such as diversified funds of hedge funds or composite indices, or (iii) a mix of single strategy indices. These options all have pros and cons.

Investors have complete flexibility when investing in hedge funds as they do not have to delegate either the portfolio construction or fund selection process to a third party. The flipside, however, is that hedge fund investing is reserved for sophisticated investors as the selection process is extremely challenging in the alternative arena, and integrating single hedge funds in a traditional portfolio is not straightforward. Investing in standard solutions, on the other hand, presents the advantage of benefiting from the fund manager’s experience and eventual talent. The downside is that investors delegate the whole investment process to a third party, and as a result, lose control over both the portfolio construction and fund selection processes. The lack of flexibility engendered results in a loss in terms of diversification potential. Another solution consists of investing in a mix of style indices. By doing so, investors circumvent the difficulties of the fund selection process and keep control over the portfolio construction process. Nevertheless, there is a caveat. Indices are not all created equal. Investors must therefore pay particular attention to the fit between the characteristics of the indices and their specific needs.

We finally analyse European institutional investors’ answers to find out how they typically gain exposure to hedge fund strategies. As we might have expected, 74% of European institutional investors invest in hedge funds through diversified funds of hedge funds, but only 37% invest directly in single hedge funds. More surprisingly, while European institutional investors appear to be inclined to delegate the portfolio construction process (i.e., they systematically favour multistrategy investment vehicles over single strategy vehicles), very few appear to be ready to delegate the selection process. Respectively 82% and 61% of European institutional investors rely on internal expertise to select single hedge funds and funds of hedge funds. The efficiency of both the portfolio construction and fund selection processes is thus seriously challenged since (i) the beta benefits of hedge fund can only be maximised by taking investors’ initial allocations into account, and (ii) institutional investors do not appear to possess the requisite resources to carry out fund selection properly.

Investing in a mix of style indices presents the advantage of (i) circumventing the difficulties of the selection process, while (ii) keeping control over the portfolio process. One might thus have expected investors to invest massively in style indices. However, this is not the case since only 2% of European institutional investors invest in single strategy indices. This choice appears to be motivated by the fact that European institutional investors consider that indices provide them not only with fewer selection choices, and in turn, with scarcer positive returns, but also with lower decorrelation with traditional asset classes. We argue that none of these arguments really holds. As a result, we believe that hedge fund indices are bound to experience tremendous growth in assets under management over the next few years.

Hedge Funds in Asset/Liability Management

The objective of the fourth part of the document is to show the role that hedge funds can play in asset/liability management. To this end, we present the different forms of asset/liability management techniques (i.e., cash-flow matching, immunisation and surplus optimisation). We subsequently show that hedge funds can either be seen as a supplement or a complement to traditional asset classes. On the one hand, hedge funds can be considered to be an additional strategic asset class. However, as we shall see, this approach poses both conceptual and practical problems, so we do not recommend it. On the other hand, hedge funds can be seen as a complement to traditional asset classes. As we shall see, this approach has the merit of alleviating concern over ex ante modelling of hedge fund returns since hedge funds only enter the surplus optimisation exercise through the impact they have on risk parameter estimates for traditional asset classes. In an attempt to highlight the benefits of hedge funds from an asset/liability management perspective, we finally formalise the benefits of the reduction in stock and bond volatility due to the introduction of hedge funds in the context of a surplus optimisation model.

Controlling Hedge Fund Risks in the Investment Process

The aim of the fifth part of the document is to show how institutional investors can control hedge fund risks throughout the investment process. We see in an initial section how investors can mitigate hedge funds’ operational risks by conducting proper due diligence and selecting funds that present basic characteristics such as independent administration, independent risk control and appropriate back office technology. This gives us the opportunity to present the benefits and limitations of managed accounts. As we shall see, an advanced managed account platform addresses the most important risk factors identified in hedge fund debacles (fraudulent or otherwise). However, given the broad range of services managed accounts and similar platforms can provide, it remains essential for the investor to clearly understand and verify the nature of the contractual arrangements made between the management company and the service provider.

We subsequently give a brief overview of structured products on hedge funds (e.g., option-based structures, fixed-threshold structures and variable-threshold structures). We then show how investors can control hedge fund risks in the portfolio construction process by implementing appropriate optimisation techniques. To this end, we review the different optimisation techniques used in the literature to build portfolios of hedge funds. As we shall see, to fully capitalise on hedge funds’ beta benefits in a top-down approach, investors must be able to rely on robust techniques for optimisation that account for both investors’ aversion to extreme risks and the presence of parameter uncertainty. We thus introduce an innovative Bayesian model that incorporates an answer to both challenges within a unified framework. We finally elaborate on the information that hedge funds’ and funds of hedge funds’ activity reports should contain so that investors can monitor their risks properly.

We finally analyse European institutional investors’ answers to see how they control the risks of their hedge fund investments. Investors dispose of two options to deal with (downside) risk. They can either eliminate it through the use of a structured product, in which case they also have to forego some of the upside potential, or they strive to control it through proper risk management, which is much more challenging but does not eat into the upside potential. Surprisingly, despite their lack of understanding of hedge fund risks, only 38% of European institutional investors opted for the first solution. Unfortunately, as we might have expected, their practices are more often than not sub-optimal. While 67% of European institutional investors take the risk factors to which their hedge fund investments are exposed into account in their allocation, only 30% distinguish hedge funds between strategies or by grouping them into types of risks, which prevents them from taking advantage of the diversity of hedge fund strategies. In the same vein, 45% of European institutional investors do not have any allocation policy, and among the 50% following either a pure quantitative approach or a mix of quantitative and qualitative analysis, a majority opt for the mean/variance framework, which is clearly ill-suited to the construction of portfolios of hedge funds.