Roadmap to Hedge Funds (2012 Edition)
By Alexander Ineichen
Published: 01 November 2012
The following is an online summary of this particular AIMA paper
AIMA’s original Roadmap to Hedge Funds quickly became the most-downloaded publication in the association’s 22-year history, despite having been released at the height of the global financial crisis in September 2008. Four years on, it remains a powerful guide to investors seeking to create and manage a hedge fund portfolio. Written in a wry, witty style, it was a success not only because it was the world’s first collaborative educational guide for institutional hedge fund investors, but because it demystified the hedge fund industry at a time when misconceptions around issues such as short-selling, fees, transparency and risk were widespread. It had a global readership and in 2010 was even translated into Chinese.
Much clearly has changed in the four years or so since the original edition was released. While much within the 2008 Roadmap remains relevant, there has been a recognition within AIMA and its Investor Steering Committee, which co-ordinated the original release as well as reviewing this edition, that the time had come for a substantial update to be published. This edition is what emerged from those discussions.
As with 2008, the new edition of the Roadmap has been authored by Alexander Ineichen, one of the leading authorities on hedge funds. Alexander started his financial career back in the 1980s, and the Roadmap reflects his considerable knowledge. In addition to the Roadmap, he is the author of the most printed research publications in the documented history of UBS - “In Search of Alpha - Investing in Hedge Funds” (October 2000) and “The Search for Alpha Continues - Do Fund of Hedge Funds Add Value?" (September 2001). He is also the author of "Absolute Returns - The Risk and Opportunities of Hedge Fund Investing" (Wiley Finance, October 2002) and “Asymmetric Returns - The Future of Active Asset Management” (Wiley Finance, November 2006).
Broadly speaking, what this new edition has set out to do is to explain the continuing relevance of hedge funds after the tumult of the last four years. All of the data from the 2008 edition have been updated, and Alexander has identified new trends and developments.
It is worth recording that amid the upheaval, hedge funds in general have recovered fairly well from the crisis. At the time of writing, the industry had just reached a new peak of $2.2 trillion in assets under management. We believe the key force behind this rebound has been the evolving hedge fund investor base.
What is undeniable is that attitudes to hedge fund investing have changed since 2008. Hedge funds are now a truly institutional product. Pension funds have become a lot more familiar with the asset class, and, as a result, continue to seek hedge fund investments as a means to diversify away from their traditional bond/equity portfolio construction, and to seek superior risk-adjusted returns. The industry is arguably better understood, more transparent, better governed, and, as a result, more respected to service an institutional investor base.
The changing investor base is driving a structural change within the hedge fund industry. Institutions have arrived with their own set of client demands, distinctive from those of the pioneer high net worth and family office investors. They have demanded improved transparency, increased reporting and top quality risk management systems. This, coupled with a new wave of industry regulation, has resulted in real change at the hedge fund manager level. It has also driven an increase in demand for managed accounts, a trend likely to continue. Further, institutional investors have begun to put pressure on the traditional 2-and-20 fee structure. We predict that this trend will continue, and that flexible fee structures will become the norm.
This institutionalisation has inevitably had an effect on the quality and quantity of start-up hedge fund managers. Barriers to entry have increased. Higher regulatory standards translate to higher costs for a start-up. As a result, the new launch pipeline is now dominated by talent from prop desk spinouts and “second generation”, high-pedigree managers. Inevitably, in an increasingly institutionalised world, only those with a strong track record, proven alpha generation capabilities, strong operational experience and tested business management will be well positioned to raise capital.
Funds of funds, still an important source of hedge fund capital, have also evolved dramatically since 2008. Many have successfully adapted their business models, and are now playing a key role alongside consultants, using their industry expertise to provide advisory assistance as well as discretionary services for the end investors.
Alexander has provided invaluable research that summarises the hedge fund industry over the past decade. His books and articles have hugely contributed to the institutionalisation of the industry. We are certain that you will enjoy reading the Roadmap. We trust that it will provide insightful research and relevant information (as well as many wise quotes from a wide range of sources) both for newcomers and for seasoned hedge fund veterans.
Finally, a word of thanks is due to all of those people who gave of their time and expertise during the production of both the 2008 and 2012 editions of the Roadmap, including of course the author Alexander Ineichen (of Ineichen Research and Management AG), Tom Kehoe of AIMA, Craig Dandurand of CalPERS and Kurt Silberstein of Ascent Private Capital Management (and formerly of CalPERS). Special thanks are due also to the CAIA Association. All of their contributions have been invaluable.
Managing Director & Global Head of the Hedge Fund Capital Group
Alternative Investment Management Association
A hedge fund constitutes an investment program whereby the managers or partners seek absolute returns by exploiting investment opportunities while protecting principal from potential financial loss. The first hedge fund was a hedged fund.
The favourable relative performance of hedge funds is worth highlighting: a hypothetical investment in the S&P 500 Total Return Index of a $100 at the beginning of the last decade stood at $121 by August 2012. A hypothetical investment of $100 in the HFRI Fund Weighted Hedge Fund Index stood at $201. We think this is a big difference.
The average hedge fund portfolio fell 20% in 2008. However, recovery was swift. It is easier to recover from a 20% loss than it is to recover from a 50% loss. The average hedge fund reached high-water mark, i.e., recovered from its 2008 losses, by October 2010, judging by HFR index data. Global equities on the other hand, have been under water since 2007 and, assuming an annual growth rate of 5%, will only have recovered their financial crisis losses by 2015.
In the ten worst quarters since 1990, a diversified hedge funds portfolio lost less than a global equities portfolio.
Managed futures delivered a positive return in 18 out of 20 equity down-markets between 1980 and 2012.
One way to look at hedge funds is as active managers. While many aspects of hedge fund investing have indeed changed since 2008, the concept of active risk management has not. In fact, we would argue that the case for active risk management has increased over the past four years.
Hedge funds are active risk managers. Active risk management is dependent on the willingness to embrace change and, more importantly, to capitalise on it. Adaptability is the key to longevity.
The term “risk-free return” stems from models in the laboratory environment of financial academia, the model world, not the real world. It describes an econometric nirvana; a place where there is no risk.
An increasing number of investors have been arguing that there is no such thing as a safe place for wealth to rest; governmental guaranteed investments included. Furthermore, while there is no such thing as a risk-free rate, there seems to be plenty of return-free risk.
The pursuit of absolute returns is much older than the idea of beating a benchmark. Defining risk as the attempt to avoid losses is materially different than trying to avoid underperforming a benchmark.
Hedge funds do not hedge all risks. If all risks were hedged, the returns would be hedged too. Hedge funds take risk where they expect to be paid for bearing risk while hedging risks that carry no premium.
Today, after equities halved not once but twice within a decade, the absolute return investment philosophy has become the norm among certain types of investors. The fact that real interest rates are negative in certain areas of the world has increased the demand for absolute returns further; thereby strengthening the investment case for managers who have capital preservation as their main risk management goal.
Every investment management professional as well as nearly every citizen of the industrial world will agree that the financial services sector is not the same as it was prior to the 2008 financial crisis. Everything has changed. For example, while the hedge fund industry is still a fraction of the size of the banking industry, it seems to have recovered better: the ratio between the market capitalisation of all the 46 European banks in the STOXX 600 index to assets under management in the global hedge fund industry was 1.2:1 at the end of 2006. By the end of Q3 2012 this ratio shrunk to 0.4:1 as the market capitalisation of European banks was 57% lower while hedge fund assets were 50% higher. And the two-decade long growth of the hedge fund industry, while interrupted by the events of 2008, has continued. In 1990, the assets under management in the hedge fund industry were 50% of the market capitalisation of Apple, Microsoft and Exxon Mobile combined. By the end of 2000, hedge fund assets were 90%, and by the third quarter of 2012 182% of the market capitalisation of Apple, Microsoft and Exxon Mobile. While there was disappointment with absolute returns in hedge funds, the average hedge fund regained its high-water mark by October 2010 and the hedge fund industry started to print new record highs in terms of assets under management by early 2012. Furthermore, whereas large parts of the financial system were perceived as too big to fail and were indeed saved by the authorities and their underwriters, the tax payer, individual hedge funds are generally small enough to fail and never in the history of hedge funds did the industry require subsidies from the tax payer.
The 2008 financial crisis has added more question marks about the role and practicability of financial economics (MPT, CAPM, alpha, correlation coefficients, autoregressive conditional heteroskedasticity, etc.). There is a big difference between the model world and the real world. The model world was always the model world and everyone knew it. US economist J.K. Galbraith brought it to the point in the side text: For believing that a government bond-heavy portfolio is investment panacea one has to ignore nearly all economic systems and socioeconomic experiments that have failed. In an environment where the inappropriately named risk-free return has turned into return-free risk, holding on to investment dogma and ideas that worked well in the past, might be the biggest risk investors face today. Keeping an open mind could become essential to prosperity and, potentially, investment survival. This Roadmap needs to be read with this in mind, with certain receptiveness for different perspectives, unorthodox thought and new ideas.
We quite often come across the notion that financial economics needs its Einstein to break with the current intellectual gridlock of traditional investment thinking and belief. Einstein’s insight caused—to use Thomas Kuhn’s words—a paradigm shift resulting in many old beliefs turning out to be false and replaced with new-andimproved better ones. Einstein came out of nowhere, i.e., his early groundbreaking papers were published not when he was part of the academic establishment but when he was working at a patent office in Bern. We find the comparison with Darwin more apt. Einstein’s revolution came out of the blue while Darwin’s paradigm shifting insight did not. There was great disbelief of the prevailing orthodox paradigm over many decades prior to the publication of On the Origin of Species in 1859. However, On the Origin of Species tied all the bits and pieces together in one theory. In finance we are in the 1840s or early 1850s, i.e. there is enough evidence to claim the prevailing orthodoxy to be false but we do not have a new theory tying the “bits and pieces” together. The practical relevance of this is that regulation and accounting rules are still based on the assumption that there are indeed fairies, as Douglas Adams put it in the side text, at the bottom of the garden. MIT professor and hedge fund manager Andrew Lo once referred to the hedge fund industry as the Galapagos Islands of the financial services industry. It is there where false orthodoxy is broken and new ideas are tested.
Both frogs and snakes live in the real world. When a frog-eating snake enters the habitat of frogs, what happens? The frogs either adapt to the new environment or become snake food. This, in the tiniest of nutshells, is how flora and fauna works. It is a robust system and it has been going for a couple of billion years, even if it can be tough for frogs at times.
Finance is different. Not all market participants live in the real world. Hedge funds live in the real world of mark-to-market accounting. They live in constant fear of margin calls and redemptions. This fear might be unpleasant for the individual at times but it strengthens the system, thereby making it more robust. Small errors are quickly revealed and corrected. Furthermore, hedge funds, more often than not, have their own wealth tied to the wealth of their investors. This means that not only are they held accountable by their agents, they feel the pain of losses as principal as well. They have skin in the game.
Not all financial services firms live in the real world of mark-to-market. For many decades, the authorities have created a financial nirvana whereby certain assets can be held at cost and thereby not holding anyone accountable for losses. This results in small errors becoming large errors and small losses becoming gargantuan losses for which the taxpayer has been, involuntarily, the underwriter. It could well be that this is in the process of changing with hedge funds becoming a larger and more important part of the financial services industry. With more actors having skin in the game, the stability of the financial system would improve. After all, whoever has washed and polished a rental car?
Many investors have noticed that hedge fund returns since the financial crisis have been disappointing, with 2011 a particularly poor year, although performance has recovered somewhat at the time of writing. A fact less well publicised is that risk taking has been low too. Returns are a function of taking risk. Many practitioners in the field of investment management have called the “risk-free return” the “returnfree risk.” The term “risk-free return” stems from models in the laboratory environment of financial academia, the model world, not the real world. It describes a starting point, an econometric nirvana; a place where there is no risk. Most often, the risk-free rate of return is associated with the authorities in one form or another, for example the return from T-Bills. An increasing number of investors have been arguing that there is no such thing as a safe place for wealth to rest; governmental guaranteed investments included. Sovereigns have failed before; even empires and reserve currencies have failed before. Furthermore, while there is no such thing as a risk-free rate, there seems to be plenty of returnfree risk. This means that many strategies that used to work do not anymore. Survival, therefore, requires change and change requires flexibility and adaptability.
The financial market place has arguably not been and is not running as smoothly as one would wish. One reason for market malfunction is market intervention. The monetary authorities, for example, have taken over risk management, or so it seems. In the 1990s, this was called the Greenspan put and now is called the Bernanke put, while there is now also a Draghi put. The extent of intervention has reached a multi-generational extreme. The main differentiation of hedge funds, as this Roadmap will elaborate on, is active risk management. As any risk manager will attest, the current investment environment is difficult. There is a sense that a can cannot be kicked down the road indefinitely. At one state the market will indeed clear. The historically low risk that hedge funds have on their books, and subsequently the low returns, are a function of something just not being right. The current regime does not pass the capitalist-common-sense smell test. It is the responsibility of the active risk manager to act responsibly even, or especially, in times where the authorities do not.
Interestingly, the authorities are making it increasingly more difficult to hedge and manage risk responsibly. One example is the various short selling bans that have been implemented either temporarily or permanently. Short selling is one of the techniques that the active risk manager uses to control risk. Banning short selling is like banning barracudas in the Amazon: It might be a positive for the fish that grew too fat and are too slow to adapt to change, but it disrupts the ecosystem and potentially kick-starts a negative feedback loop that results in collapse. Intervention restricts the operational flexibility of the active risk manager in terms of portfolio construction, short selling and the use of leverage. The result is higher cost, higher complexity (because complex instruments need to be used to circumvent the restrictions), and higher regulatory uncertainty (because the regulatory framework, and therefore the investor’s habitat, keeps changing all the time). The bottom line is that the investment life is becoming more difficult. Nevertheless, hedge funds are still more flexible when compared to other pooled assets and are therefore potentially better equipped to adapt to change.
Hedge funds, by comparison to nearly all financial services firms, are lightly regulated. What is the result? Failures are quickly absorbed within the industry and without taxpayers’ money.  Furthermore, failure is permitted. Failure is an essential part of progress that is in any social system (as well as in nature) a function of trial and error. It is essential to the efficient allocation of capital, essential to innovation, to improvement, to growth, to everything. The hedge fund industry experienced a major disruption in 2008 too, like all financial service providers and investors. However, the hedge fund industry had adapted to the new environment quickly and recovered from the shock rather swiftly. Investors redeemed from those who they believed treated them unfairly as well as requiring more liquidity and transparency for new investments. Some business models and investment ideas disappeared while new ones had arisen within two years. This is how it should be. One reason why capitalism is superior to everything that has been tried is the swift reaction to a new situation and the swift and efficient reallocation of capital. The hedge fund model has adapted to change and is now reasonably robust. This obviously cannot be claimed for all parts of the financial services sector.
The AIMA Roadmap to Hedge Funds from 2008 was initiated prior to the 2008 financial crisis to clarify, educate, inform, and demystify hedge funds with those institutional investors who not yet had the inclination or resources to study the benefits and risks of including hedge funds in their balanced portfolios. This goal has not changed; neither has the value proposition of hedge funds. Nearly everything else has changed though. The author would like to thank Mark Anson, Craig Dandurand, Gumersindo Oliveros, Sanjay Tikku, Kurt Silberstein and Tim Williams for their invaluable comments and insights. A special thanks goes to Anita Nemes from Deutsche Bank and Tom Kehoe from AIMA for making it all happen. The author is solely responsible for errors and omissions. Opinions are the author’s own.
The author would like to thank Mark Anson, Craig Dandurand, Gumersindo Oliveros, Sanjay Tikku, Kurt Silberstein and Tim Williams for their invaluable comments and insights. A special thanks goes to Anita Nemes from Deutsche Bank and Tom Kehoe from AIMA for making it all happen. The author is solely responsible for errors and omissions. Opinions are the author’s own.