Mini-Course Series - Alternative Investments (Part 2 ) by Institute of Business & Finance

MINI-COURSE SERIES ALTERNATIVE INVESTMENTS Part II

ALTERNATIVE INVESTMENTS

INTRODUCTION TO HEDGE FUNDS An accurate, but somewhat cynical definition of a hedge fund comes from AQR Capital: “Hedge funds are investment pools relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money.” Hedge funds today can have an edge due to several developments: [1] Ability to go short [2] Can go short and long on similar assets [3] Use of leverage [4] Use of computers and databases [5] Introduction of new futures and derivatives [6] Extremely fast large trades possible through computers [7] Trading commissions are now very low [8] Potentially high compensation attracts bright managers In short, hedge funds attempt to exploit small market anomalies. A hedge fund often starts out with a little bit of the GP’s money in it. The majority of the fund is made up of LP money. As time passes, the GP accumulates wealth via incentive and management fees. The LPs withdraw to pay their obligations. The fund closes itself off to new investors. After many years of successful returns, the GP ends up his own biggest client, essentially becoming a massive account for the GP and its employees.

Simple Example: Discounted CEFs An IPO closed-end fund (CEF) represents one way a hedge fund can exploit a market anomaly. These IPOs frequently contain an 8% gross selling commission paid to the brokerage firm; surprisingly very few investors ever ask whether or not the IPO contains any kind of selling fee. The IPOs are attractive because they typically offer a comparatively high initial rate of return (bond funds) or an appealing investment strategy (stock funds). Brokerage firms push these products because of their fee structure. However, once the fund is sold out and there is no longer any promotional push, investors are often left with a product trading at a 10–20% NAV discount. This is when hedge funds make a discounted offer to CEF shareholders.

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A hedge fund is an investment vehicle managing a concentrated portfolio of securities and/or derivatives; the portfolio may be leveraged and can usually invest both long and short. Hedge funds can be differentiated from traditional mutual funds in six ways: 1. Pooled resources of sophisticated investors—under SEC rules, in order to avoid a number of regulations, a hedge fund cannot have more than 100 accredited investors (defined as someone with a minimum net worth of $1 million or income of $200,000–$300,000 if married—for each of the past two years; the fund may also accept money from no more than 500 qualified purchasers—individuals or institutions that have a net worth > $5 million). 2. Concentrated holdings—management does not need to worry about benchmark risk; the strategy tends to focus on a single theme or market segment. 3. Generous use of derivatives—hedge funds tend to use derivatives much more than traditional mutual funds; derivatives can reduce or enhance risk, depending upon the instrument and how it is used. 4. Long and short—market direction may not be important since the fund can usually go short or long; traditional money managers generally only go long. 5. Nonpublic securities—securities that do not include a public offering or prospectus; many convertibles and high-yield bonds are known as 144A securities—debt or hybrid instruments issued to institutional investors in a private transaction. 6. Leverage—although mutual funds may not borrow more than 33% of their net base amount, hedge funds do not have this restriction; leverage of 10-to-1 or more is used by some managers (note: more leverage, more “assets under management” and a larger management fee). Alfred W. Jones began the first hedge in 1949; the fund invested in common stocks and had the goal of minimizing risk by going long and short. During the 1973–74 recession, when the S&P had a cumulative loss of > 50%, many hedge funds were liquidated. Hedge funds did not become popular again until the late 1990s. Today, there are > 11,000 hedge funds managing ~ $2 trillion. Returns for 2011 were -5%.

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ALTERNATIVE INVESTMENTS

MERRILL LYNCH FACTOR MODEL The Merrill Lynch Factor Model—Exchange Series is a benchmark designed to have the same risk and return characteristics of hedge funds; the objective is to match the risk, return, and correlation to the HFRI Fund Weighted Composite Index (HFRI). The HFRI is made up of > 2,000 hedge funds; the index is adjusted each month, increasing the long or short exposure of six underlying indexes (see table).

HFRI Index Composition [1/5/2012] Index Exposure

Weight

3-Month T-Bill

67%

S&P 500 Total Return Index

-10%

MSCE EAFE USD Total Return Index

21%

MSCE Emerging Markets USD Total Return Index

EUR/USD Exchange Rate

Russell 2000 Total Return Index

14%

The indexes comprising the HFRI Index are “each weighted monthly from +100% to 100% (except the MSCI Emerging Markets, which is weighted between +100% and 0%, 3-month T-bills, which may be weighted between +200% and 0%, plus the Russell 2000, which is weighted between +100% and -30%). “For each monthly rebalancing, the systematic regression analysis seeks to determine which direction (i.e., long or short/flat) and weighting for each of indexes over the previous 24 month period (ending on the month for which the most recent closing level of the HFRI is available) would have produced the highest correlation with the HFRI. The indexes are then weighted according to the results of the analysis. In no case will the sum of the factor weights (excluding 3-month T-bills) be greater than +100% or less than -100%” (source: ProShares Hedge Replication ETF prospectus, dated July 2011). During July 2011, ProShares launched an ETF (symbol HDG) that tracks the performance of the Merrill Lynch Factor Model—Exchange Series. The ETF has an annual expense ratio of 0.95%. Since its inception, the ETF returned -2% vs. -0.1% for SPY (S&P 500 ETF) as of January 18, 2012.

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THE GOAL OF INCLUDING HEDGE FUNDS The client’s investment objective is usually either to increase return potential or reduce risk. A hedge fund may reduce the portfolio’s overall risk, and/or it may be viewed as a means of potentially enhanced returns. One way a hedge may add to a portfolio’s return is by using a market strategy or by specialization in an area not normally covered by ETFs, mutual funds, or variable annuities. Looking first at specialization, consider a sector mutual fund compared to a hedge fund. Assuming similar expertise, the mutual fund is likely to be long only; the hedge fund can go long and short to a degree the mutual fund is forbidden by regulation or fund policy. It is the long-only restriction that causes the greatest amount of lost alpha potential for the active manager who invests in traditional equities and fixed income. Institutional and individual investors typically have a portfolio that includes index and actively managed funds as well as possibly additional positions in small or mid cap value or growth oriented equities. However, these same investors often do not include private equity investments because the learning curve is extreme or the risk level appears to be too extreme. In the case of risk, numerous studies, some of which are cited herein, clearly show hedge funds can have dramatically less risk than traditional asset categories, including highdividend stocks and 10-year Treasurys. However, the advisor needs to make sure the hedge fund’s investment policy does not allow moderate or large leveraging which could greatly increase the hedge fund’s volatility (while making any low standard deviation figure published meaningless—and misleading). The amount of high leverage used by some hedge funds has resulted in investor losses of 70–100% within a matter of weeks or months—the kind of horrific and sudden loss that would not be experienced with a mutual fund whose leveraging abilities are minor, if they exist at all. Even a 3x ETF has not gone through the kinds of losses some hedge funds have experienced over the past 10–20 years.

Fund of Funds As noted earlier, a hedge fund of funds (FOF) invests in a number of other hedge funds, usually 10–20 or more. Such diversification reduces the idiosyncrasies of a specific manager and/or the unsystematic risk associated with the fund’s investment style. It can also greatly diminish the chances of some “cowboy” manager who suddenly decides to leverage positions by 100–3,000%. A fund of funds is simply an example of safety in numbers—the advisor must decide if the extra layer of fees warrants such protection (which it probably does). Another way to look at a fund of funds is if the investor is using MPT principles. PART II

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ALTERNATIVE INVESTMENTS

A fund of funds may start with the universe of over 11,000 hedge funds or reduce that number down to ~ 5,000 by relying on a database from an institution such as Hedge Fund Research, Inc. The number of potential candidates is further reduced to 100–200 by whatever quantitative screens the FOF uses (returns, draw downs, style, risk level, years track record can be verified, etc.). The final candidates, which are likely to be 10–50, are determined based on phone interviews, on-site visits, client reference checks, and a review of the fund’s trading philosophy. The universe of funds can be broken down into two broad camps: diversified and equity-based, as shown in the table below. A 1998 study by Henker (Journal of Alternative Assets, Winter 1998) focused on three hedge fund styles: equity long-short, event-driven, and relative value arbitrage. His conclusion was that a fund of funds incorporating about five funds from each of these three styles will come close to maximizing the benefits of diversification. Another 1998 study by Park and Staum (Journal of Alternative Investments, Winter 1998) started with a universe of over 1,200 hedge funds of different styles. The authors concluded a fund of funds portfolio of 20 hedge funds can eliminate ~ 95% of the idiosyncratic risk. Such findings, which cover a wide range of hedge fund categories, are consistent with Henker’s work that reviewed just three investment styles.

Categorizing Hedge Funds Diversified

Equity-Based

Equity long-short

Distressed securities

Convertible arbitrage

Short selling

Event-driven

Market neutral

Activist investing

Merger arbitrage Fixed-income arbitrage Relative value arbitrage Global macro

It makes sense that the increased safety from a FOF approach is going to reduce return potential. As noted in an earlier table, HFRI FOF index had returns that were ~ 400 basis points < HFRI Composite index.

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Replacing Bonds The advisor may find portfolio efficiency can be increased by getting rid of two categories often considered a drag on performance: quality bonds and cash equivalents. For example, the HFRI FOF index usually generates lower risk and higher returns than U.S. Treasury bonds. A 1999 study by Lamm (Journal of Investing, Winter 1999) considered just such a proposition. Lamm’s working premise was that hedge funds, when used with traditional stocks and bonds, could be a cash and bond equivalent. His analysis showed such a strategy made portfolios more efficient across the entire risk frontier.

A Pension Fund’s Use of Hedge Funds According to Anson (Handbook of Alternative Assets, John Wiley, 2006), a large U.S. pension plan successfully used hedge funds within the following parameters:

Hedge Fund Parameters Portfolio of Hedge Funds

Individual Hedge Fund Strategies

Target return: 10%

Target return: 8–15%

Target volatility: 7%

Target volatility: 10–15%

Largest acceptable drawdown: 10%

Largest acceptable drawdown: 15%

Liquidity: semiannual

Correlation to U.S. stocks: 0%

Max. correlation to U.S. stocks: 50%

Correlation to U.S. bonds: 0%

Max. correlation to U.S. bonds: 50%

Hedge fund style: diversified

Style: convergence trading, corporate restructuring, and market directional

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THINGS TO DO  Your Practice Phone up the spouse of one of your best clients. Tell them you want to throw a surprise birthday party for the other spouse. Get a list of the client’s friends from the spouse and invite them to a birthday lunch.  The Next Installment Your next installment, Part III, will also cover hedge funds (the negatives). You will receive Part III in a few days.  Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

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