TW EU 2012 25068 Hedge Fund Investing Opportunities and Challenges

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Contents


3/44Hedge fund investing 01

Contents

Introduction Industry sees rapid evolution 02

Section one Industry trends 05

Managed accounts 06

Risk mitigation meets cost and complexity

UCITS hedge funds 12

Opportunity for all or accident in waiting?

Hedge fund fees 16

Towards a fairer deal

Section two Strategy review 20

Event-driven strategies 22

A decorrelated opportunity set

Managed futures/systematic strategies 26

Does quant macro work?

Active currency 28

A genuine hedge fund strategy?

Section three Hedge funds for less 30

Alternative beta 32

An introduction

Reinsurance 34

Strong stomach needed for proven strategy

Emerging market currency 36

Persuasive long-term fundamentals

Volatility 38

Clear premium: diversifying?

Summary Hedge fund research

Time and effort well spent 41


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IndcnIndustry sees rapid evolution

Introduction


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01 Industry trends



Scn onIndustry trends

As institutional demand for hedge funds has increased, it is

no surprise that we have seen considerable changes in the

requirements for product delivery. In this first section, we

examine some of the current structural changes in the industry

and how they affect the ways in which investors choose to

invest. We argue that the structure and vehicle associated witha hedge fund investment is as important as the investment

strategy itself. We focus on:

The pros and cons of managed accounts.

A popular structure since the financial crisis.

Managed accounts can of fer control, ownership,

liquidity, transparency and customisation to a

portfolio, but there are challenges too: control

may not be as complete as hoped for; not

all hedge funds are willing to run managed

accounts and the costs tend to be high. We

feel that alternatives that lie in the middle

ground between direct investment and

managed accounts should be considered.

The growth of UCITS hedge funds.

These offer apparent transparency and

liquidity, which are sought-after commodities

post-Lehman/Madoff. However, before rushing

in, institutions should pause for thought: those

that have rounded out their due diligence teams

are already in a position to receive considerable

additional transparency over their investments.

Additionally, few longer-term investors actually

require daily liquidity. In addition, restrictions

on UCITS mean some of the best-performing

managers are not available outside the

traditional offshore hedge fund sector.

Fees.The balance of power is shifting away from

managers in favour of investors. Hedge fund

managers that provide genuine alpha can deserve

their fees and driving too hard a bargain with them

can be counter-productive, but investors should be

aware that their negotiating hand is now stronger

and that there are a number of possible fee

structures of which they can take advantage.



Why the increased interest?

While managed accounts have existed for

many years, the level of interest has increased

significantly since 2008. Interest in managed

accounts tends to be counter-cyclical to hedge

fund performance, waning when returns are strong

and gaining in periods of weakness. The problems

experienced by hedge fund investors in 2008 and

2009 including the gating of assets, question

marks over valuation approaches and exposure

to the Lehman and Madoff collapses led to a

sharp rise in appetite from investors looking to

access hedge fund strategies via a transparent

and liquid structure over which they have more

influence and control. According to InvestHedge,

in 2011 there were nine dedicated managed

account platforms with US$25 billion in assets,

as well as at least 18 funds of hedge funds (FoHF)

either building platforms or investing through

separate accounts. In particular, fund of hedge

fund managers who lost significant assets in

2008 and 2009 see separate accounts as a way

to differentiate their product and as a channel for

raising additional assets.

Managed accounts explained

In managed accounts, an investment manager is

appointed as an independent advisor of the account

but, unlike pooled funds, the legal ownership of the

assets remains with the client or with a managed

account platform provider.

Managed accounts, also referred to as separate

accounts, can be set up by individual clients or

accessed through a managed account platform

provider, which reduces the administrative burden.

Depending on the platform and account type,assets may be co-mingled with those of other

platform investors. The level of service offered by

managed account platforms, and consequently

the fees, can vary from being simply a conduit for

investing to a tailored fund of managed accounts

solution providing the same asset allocation

services as a typical fund of funds.

Managed accounts

Risk mitigation meets cost and complexity

01 Industry trends



Advantages of managed accounts

Proponents see the following benefits of investing

through managed accounts:

1. Better control and ownership of assets

In a managed account, the assets areultimately owned by the investor. In addition to

the increased liquidity and transparency this

provides (see below), the assets are held by

an independent custodian, meaning that the

existence and pricing of the assets can be

independently verified. Following incidences of

hedge fund fraud in 2008-09, many investors

have sought increased protection. There are

other ways of achieving this, however, such as

using third-party risk aggregators. Similarly, the

majority of hedge funds now use independent

valuers for many unquoted assets and for

reviewing valuation policies. Our belief is that

reviewing the valuation policies of a fund should

be part of the due diligence process for any

client investing in hedge funds, especially

those that allocate to less liquid assets.

When investing through managed account

platforms, the assets are held in a separate

account by the platform provider. While

investors are protected against the manager

suffering issues, they remain vulnerable

to liquidity problems in the case of heavy

redemptions from the managed accountplatform if assets are co-mingled.

Advocates of managed accounts also point

to the benefit of control. Pooled funds are

dependent on the directors of the fund acting in

their best interests. While boards are structured

with this aim, some have had cause to question

their independence. A managed account avoids

this issue as the investor has ultimate control

and thus the final say on decisions.

2. Increased liquidity

Given that investors retain ownership of the

assets in the managed account and are able toreplace the manager if they choose, managed

accounts provide ready potentially daily

liquidity. This increased liquidity is expected

by investors to provide a reliable exit route

in contrast to pooled funds, which can be

gated. However, regardless of the terms of

the account, speed of realisation is ultimately

determined by the liquidity of the underlying

assets. In times of market crisis, redeeming

managed account investors could receive their

assets in specie. Additionally, if the manager

is terminated, the liquidation and unwindingof complicated or little-traded positions may

require detailed knowledge and experience.

3. Transparency enhancements

Separate account holders are often provided

with more transparency than investors in

pooled funds they may be able to receive

full portfolio holdings lists on a daily basis.

This extra transparency provides investors withthe ability to monitor risks on a real-time basis.

As such, they are able to identify and scrutinise

risk factors such as concentration, leverage,

liquidity, exposures and style drift on a very

regular basis.

The value of transparency is largely dependent

on what the investor does with the information.

While there may be potential to add value

through dynamic asset allocation, this requires

the investor to have greater skill in timing the exit

and entry of opportunities than the underlying

managers. Furthermore, in order to exploit theadvantages of additional transparency, investors

need a risk system capable of absorbing

daily holdings information and modelling their

positions. Managed account platforms typically

provide such risk measurement and aggregation

systems services as they are needed. Given that

institutional investors typically have a long-term

horizon and are not looking to tactically trade

their hedge fund port folio exposures, few have

the need for daily transparency.

4. Protection in the event of redemption pressures

If managed account investor assets are notco-mingled with those of other investors, they will

not suffer through the realisation of the bid-offer

spread as in a pooled fund. However, typically,

there is significant overlap between managed

account assets and those of pooled funds. In

more extreme events, heavy redemption requests

from the pooled fund will result in the forced sale

of assets and managed account investors are

likely to see a downward price impact.

5. Greater customisation possible

The managed account structure allows

investors and platform providers to customisetheir investment and stipulate investment

restrictions for example restricting position

sizes and maximum leverage limits. Such limits

can significantly reduce the potential impact

of negative events on the strategy and limit

style drift. However, having a specific set of

restrictions applied across all strategies can

significantly limit a managers scope to generate

returns. Also, while leverage and concentration

can increase left-tail risks, they can also be

useful tools for alpha generation in the hands

of skilled managers. So restrictions are a majorsource of tracking error for managed accounts.



In addition, investors looking to avoid highly

levered or highly concentrated strategies could

achieve this alternatively through the selection

and monitoring of their hedge fund managers.

6. More attractive fees

The managed account structure provides

managers with a way to circumvent

Most Favoured Nation clauses which apply to

pooled funds, so there may be scope to negotiate

more attractive fees from the investment

manager. However, this is traded off against the

additional costs to the manager and investor

of the managed account structure. Managed

account platforms tend to be expensive, typically

charging fees in line with those of a fund of

hedge funds provider. Improved fee structures

can equally be achieved by creating a separate

share class within a pooled fund structure.

Disadvantages of managed accounts

1. Adverse selection bias

Historically, managed accounts were viewed

as structures provided only by second-class

managers who struggled to raise assets through

other vehicles. While the events of 2008 and

2009 have meant a greater number of managers

are willing to provide managed accounts,

particularly those who lost assets through 2008

and 2009, there are still a large number of

hedge funds that remain strongly against thesestructures, resulting in an adverse selection bias.

In other words, investors will not be able to gain

access to some of the best funds.

In addition, the ability to provide managed

accounts varies by strategy. Some strategies will

simply not be available. For example, it is usually

straightforward for Commodity Trading Advisor

(CTA) managers, who invest primarily in highly

liquid forward and futures contracts, to provide

separate accounts. However, other strategies are

less suitable, including debt or equity strategies

which invest in private transactions, strategiesfocused on less liquid assets and those that look

to exert control over companies. This is because

of the difficulty in valuing these positions, the

inability to split allocations across different

accounts and the required minimum deal sizes.

Many managers choose not to run separate

accounts because of the administrative

burden. Managed accounts create additional

costs and complexity for managers, including

initial set-up costs, the cost of implementing

positions across numerous accounts, adhering

to tailored guidelines and monitoring numerous

accounts. As a result, some managers may

require a significant minimum investment (up

to US$100 million when setting up a managed

account). Additionally, some managers do not

like managed accounts as they make it more

challenging to create equality of terms and

transparency across clients. Some managers

also perceive that providing transparency

results in confidential information beingreleased which could degrade their ability to

pursue the strategy successfully in the future.

As a result of the number of managers

unwilling to offer managed accounts it may

not be possible to access the same line-up of

quality hedge funds through managed accounts

as it is through pooled fund investments. Of

our current highest-rated hedge fund managers,

only a handful offer the ability to invest via

managed accounts.

2. Increased liability

The increased transparency, customisation

and control provided through managed accounts

may mean a transfer of liability to investors, given

that they are in a better position to monitor and

control risks.

3. Reduced alignment of interests

Portfolio managers typically co-invest in pooled

funds, which should improve the alignment of

interest between manager and client. However,

managers are unable to co-invest in managed

accounts and, given tailored guidelines and

varying liquidity, this can result in a reduction in

the alignment of interests. In the extreme case

of the liquidation of a fund, it is usually better to

be invested in the same vehicle as the manager.

4. Additional costs and

administrative requirements

Following due diligence and selection of a

manager, the set up of a managed account

requires several additional steps, which are

detailed in Figure 01. In particular, setting

up arrangements with various counterparties

and service providers is likely to be onerous.

Unlike investing in pooled funds, clients (or their

advisors and representatives) are required to

negotiate their own terms (and International

Swap and Derivatives Association agreements,

or ISDAs) with service providers including prime

brokers, fund administrators, cash custodians,

security custodians, and over-the-counter (OTC)

counterparties. Investors are unlikely to negotiate

terms as favourable as the hedge fund manager

has in place because the manager typically

has greater leverage in negotiations, given their

higher asset levels and trading volumes versus

the client. However, costs can be reduced

significantly for large-scale managed accounts.Managed account platforms can provide some

of these services but platform fees can be high

and are in addition to fees paid to the underlying

hedge funds.

01 Industry trends



The managed account alternative:Funds of One

Given the costs and challenges associated with

managed account investments, some clients and

managers have looked to use a Fund of One as

middle ground between pooled fund investments

and fully separate accounts. A Fund of One can

take several forms:

A separate offshore vehicle created for one

particular client.

A separate feeder fund of an existing master

feeder vehicle.

A separate share class of an existing fund

created for a single client.

The key difference between a Fund of One and

a managed account is that the manager retains

ownership and control of the assets, is responsible

for the custody of the assets and retains all the

counterparty relationships. The extent to which

a Fund of One avoids the co-mingling of assets

with other investors depends on its structure if a

separate offshore vehicle is created, there will be

no co-mingling. However, in the case of a separate

feeder fund or share class, assets will still be mixed.

Similarly, to create tailored guidelines or customise

the strategy will require a fully separate vehicle.

Given that a Fund of One does not give away

as much control as a managed account, and

does not demand the same levels of additionaladministration, some managers who will not

offer separate accounts may offer a Fund of One.

Note that the cost of setting up and the ongoing

administrative costs of these options will be borne

by the client.

Source: White paper Separate accounts as a source of hedge fund alphaby Deepak Gurnani of Allstate and Christopher Vogt of Northbrook

Figure 01. Separate account requirements

Suitability

Legal

Guidelines

Service Providers

Counterparties

Financing

The graphic shows the main considerations and steps in setting up a

separate account with a hedge fund manager.



A solution for some, not for all

While managed accounts offer many potential

advantages to investors, including control of assets,

transparency and liquidity, we believe the costs of

these structures and the governance requirements

of operating them outweigh the benefits for many

investors. The majority of institutional investors

have naturally long-term investment horizons and

do not require daily liquidity or daily transparency

from their investments. We continue to focus on

identifying managers who are sufficiently skilled

in a breadth of strategies so that clients are not

required to time their entry and exit. In most

cases, we do not believe that having an account

with daily liquidity will provide investors with

an advantage few are equipped to deal with

payments in kind from redemptions, for instance.

We believe investors should continue to focus

on ensuring that the terms of the investment

vehicles they choose are well-aligned with the

investment horizon of the underlying assets and

that they are investing in funds where there is a

strong alignment of interests with the investmentmanager. Nevertheless, the desire for investors

to have more control over their assets and to

have more of a say in the valuation process is

causing many to examine the alternatives to

pooled funds. While a number of the benefits

of managed accounts or Funds of One can be

achieved by negotiation when investing in a

pooled product, some needs are only met

through non-pooled solutions.

01 Industry trends



Differences vs offshorepooled funds

Managed accountsManaged accountplatforms

Fund of One

Different liquidity terms Yes Yes ? Depends onindividual negotiations

Ability to exit in

crisis environment

? Likely to receive assets

in specie and ability to

exit will depend on clients

ability to find suitably

skilled replacement advisor

? Likely to receive assets

in specie and ability to exit

will depend on clients or

platform providers ability

to find suitably skilled

replacement advisor

? Depends on

individual negotiations

Control and ownership

of assetsYes

? Control and ownership

may sit with either the

platform or the client

depending on the structure

No

Different fee terms ? Depends onindividual negotiations

? Depends onindividual negotiations

? Depends onindividual negotiations

Reliant on Fund Board

acting in best interests

of fund shareholders

No No? Depends on


Protection from the impact

of other clients redeeming

? Protection from

realisation of short-term bid

offer spreads. However, given

overlap in portfolios, large

scale redemptions are st ill

likely to affect asset pricing,

particularly in the case of

less liquid assets

? Depends on the

structure of the platform,

may be impacted by flows

from other investors in the

platform and also subject

to the same concerns as

managed accounts during

large scale redemptions

No in the case of separate

share class/feeder structures

? If structured as a

completely separate vehicle

day-to-day protection but

exposed to the impact of

large scale redemptions

as with managed accounts

given the overlap in holdings

Increased transparency Yes Yes? Depends on


Customisation of strategy Yes Yes

Only available in a

completely separate

vehicle

Increased administrative

costsYes Yes

Yes albeit less than

in a managed account

Adverse selection bias Yes YesYes albeit possibly less

than for managed accounts

Requirement to negotiate

own ISDAsYes Done by platform provider No

Figure 02. Summary of options



UCITS hedge funds

Opportunity for all or accident in waiting?

UCITS hedge funds divide investment managers:

some view them as an accident waiting to happenwhile others see them as a golden opportunity to

attract assets from investors who abandoned the

industry following the financial crisis of 2008 and

to rebuild a more diversified client base. From the

investor viewpoint, the liquidity advantages have

to be set against the restrictions on shorting and

leverage, which can act as a drag on return potential.

UCITS explained

The UCITS1regulations are a set of European Union

(EU) directives that allow open-ended EU-domiciled

funds investing in transferable securities to besubject to the same regulation in every member

state. The intention is to reassure investors that

funds which have obtained UCITS approval have

met certain thresholds with regards to transparency,

liquidity, diversification and risk control.

UCITS funds have traditionally followed simple

long-only strategies and these still represent the

bulk of UCITS assets. But the UCITS directive

also allows hedge fund-like strategies to be

implemented within its framework, provided

specific risk limits are met. These are known

as Alternative UCITS or UCITS hedge funds.

Growth of UCITS hedge funds

UCITS funds have enjoyed spectacular growth

over recent years, particularly in the wake of

2008. The UCITS market as a whole represents

approximately 73% of investment assets in Europe,

or 5.6 trillion.2(As a point of reference, the entire

US mutual fund industry is 9.2 trillion.)

The number of Alternative UCITS funds now

exceeds 1,000, with around two-thirds of these

having been launched since the financial crisis.

This illustrates how transparency and greater

regulation have acted as a real catalyst for growth,

particularly among European and Asian investors.

Total assets under management (AUM) for

Alternative UCITS stands at approximately

US$115 billion.

A number of events have contributed to

this growth:

Difficulties experienced by hedge fund investors

following the financial crisis, including the gating

of assets and exposure to both Lehman and

Madoff, have created increased appetite to

access hedge fund strategies via transparent

and liquid structures.

1 Undertaking for Collective Investment in Transferable Securities.2 Source: European Fund and Asset Management Associati on,

August 2011

01 Industry trends



Institutional investors increasingly wish to

move away from benchmarked productsand invest in more flexible hedge fund- like

mandates. At the same time, offshore hedge

fund managers have looked to tap the deep

pool of pension fund assets.

Some investors have fought shy of offshore

hedge funds given increasing regulation over

recent years.

UCITS is a recognised brand across the globe

and funds can be marketed to a very broad

geographical and segmented investor base.

The demand for UCITS products from traditional

hedge fund investors is partly a reaction tothe financial crisis. European investors were

responsible for a large percentage of the

US$300 billion of global outflows from the

industry in 2008 and 2009. Investors who have

returned have tended to prefer Alternative UCITS

to traditional hedge funds. Daily or weekly liquidity,

a regulatory rubber stamp, lower perceived risk

(owing to limitations on leverage and concentration

levels) and increased transparency are all

characteristics valued by private investors, FoHFs

and family offices in particular.

Retail investors, mainly accessed via distributors

such as fund platforms, IFAs, retail banks anddefined contribution pension providers also

represent a large share of the Alternative UCITS

asset base, and are likely to be the biggest source

of growth in the future.

To date, institutional investors have, by and large,

not chosen Alternative UCITS over traditional

hedge funds, for the following reasons:

Institutions tend to be long-term investors, with

little need for daily/weekly liquidity; many would

rather capture the illiquidity premium associated

with longer lock-ups.

The constraints imposed by a UCITS structure

on concentration and leverage represent a drag

on performance.

Hedge funds have themselves improved

transparency and governance post 2008.

Institutions have boosted their internal due

diligence teams so are better placed to select

traditional hedge funds.

There are not a large number of Alternative

UCITS funds with a sufficiently long track record.

UCITS funds tend to be too small to

accommodate large institutional inflows.

Legal constraints that prevent certaininstitutions from investing in UCITS.



Alternative UCITS are currently concentrated

in the following strategies:

Equity long-short (27%): this is a reflection of

the ease with which equity long-short strategies

can be packaged into UCITS products. The

majority tend to be Europe-focused strategies.

Fixed Income (18%): these tend to differ from

their traditional hedge fund counterparts by

being absolute return rather than relative

value funds.

Mixed arbitrage and multi-strategy (15%).

Volatility trading (10%).

Credit including convertibles and emerging

markets (9%).

Macro (7%).

Equity market neutral and quantitative

strategies (6%).

Event-driven (3%). Managed futures (3%).1

UCITS suitability depends on theunderlying strategy

The decision whether to shift to a UCITS structure

depends to a large extent on the underlying

strategy. We consider below the broad categories

of hedge fund investment strategies and their

suitability for UCITS. The greatest challenges tend

to be found in credit and event-driven funds, as

well as macro and arbitrage funds.

Equity long-short

Equity long-short is the strategy which has

dominated hedge fund UCITS launches to date

and is most easily structured as UCITS given

that most equity long-short managers hold

highly liquid assets.

The main constraint for equity strategies is the

requirement for short exposures to be expressed

entirely through derivatives. The potential

increased cost of implementing short positions

through derivative instruments will impact returns.

A number of sub-strategies within equity

long-short struggle to fit into a UCITS wrapper.

These include:

Strategies that focus on less liquid equities

such as small cap or unlisted equities.

Some concentrated strategies particularly

those that use leverage fall foul of the

diversification requirements. A 5% position

in a four-times levered fund, for instance,

would breach the 20% concentration limit.

Some levered strategies may be constrained by

the 300% maximum gross exposure limitation.

Credit long-short

The key challenge for credit long-short strategies

is to maintain liquidity and to deal with the

prohibition on exposure to loans. Funds that

focus on lower credit quality issues and event

investments will struggle to offer the liquidityrequired by UCITS. The exception to this may

be credit trading funds, which make significant

use of credit default swaps (CDS). The limits on

concentration may also be an issue, particularly

where leverage is applied.

Macro and managed futures

For traditional long-term macro strategies and

managed futures managers, who primarily trade

directional views using liquid futures, restructuring

in a UCITS wrapper should present few problems.

However, more complex strategies have tended

to bear little resemblance to the offshore fundsthey are based on. The liquidity constraints and

requirements to reduce complexity are onerous

for these strategies and the number of line items

must be reduced. Similarly, high frequency trading

does not fit well with the UCITS approach. Due to

liquidity constraints, relative value spread trades

may also be removed from the opportunity set.

The limitations on cash shorts and investment

in commodities also have implications for

these funds. While some of these opportunities

might still be accessed indirectly through

derivatives, this leads to increased cost andreduced opportunity. Requirements relating to

collateralisation of derivative contracts adds

to costs and reduces the opportunity set.

The concentration limits pose further issues,

especially when leverage is applied. In particular,

the limit of a maximum 100% net exposure to

US Treasuries may limit these strategies.

Fixed income relative value and arbitrage

These strategies are likely to be required to

reduce leverage to meet VaR and concentration

constraints and may have to execute less

profitable arbitrage strategies. The constraints onshorting cash bonds may also have an impact

for example, on funds looking to exploit anomalies

between on-the-run and off-the-run Treasury bonds.

While many of these strategies can be replicated

through derivatives, this entails higher costs. We

would have concerns regarding arbitrage strategies

offering generous liquidity terms since liquidations

in adverse conditions can come at significant cost.

1 Source: Barclays Capital Prime Services, Hedge Fund Pulse,November 2011.

01 Industry trends



Event-driven

This includes distressed debt, merger arbitrage,

activist and event-driven multi-strategy funds.

These are probably the most difficult to restructure

as UCITS funds. In fact, many of these strategies

should in theory be precluded from UCITS giventheir typical long investment horizon and illiquid

nature. Furthermore, these funds can be relatively

concentrated activist investments can require a

large holding in one name. While merger arbitrage

strategies may be more liquid than some of the

credit focused event-driven strategies, securities

used in merger arbitrage may also become illiquid

at times and give rise to a mismatch with the

redemption period.

Funds of Hedge Funds

UCITS restricts investment in other funds. It requires

the target funds to be supervised in much the sameway as UCITS and restricts cumulative investments

in non-UCITS funds to 30% of net asset value. These

restrictions significantly reduce the investment

universe available to funds of hedge funds, both

in terms of the number of available funds and the

strategies that can be accessed. So the potential

for funds of hedge funds to add value through

asset allocation is reduced.

Liquidity and transparency comeat a cost

Interest in UCITS, and Alternative UCITS in

particular, has grown significantly following the

financial crisis and it seems likely that these

vehicles will continue to gain traction among

investors that value liquidity and transparency.

While there have been a number of hedge fund

launches in the UCITS space, it is not clear

that the UCITS structure suits many hedge fund

strategies. We would expect the returns and

volatility of UCITS funds to be less attractive than

those of offshore vehicles, principally due to their

inability to exploit the illiquidity premium and the

reduction in the opportunity set.

Strategies that are liquid and diversified may be

relatively easily repackaged for UCITS investors,

but other strategies are more challenged. In

particular, we note that credit, event-driven

and more complex macro strategies along with

funds of hedge funds have to undergo significant

amendments to their strategies in order to become

suitable for UCITS investors.

The primary investors in UCITS vehicles continue

to be retail investors, but the suitability of these

vehicles for institutional investors is open to debate.For the latter, which have a longer-term investment

horizon, the onerous liquidity requirements imposed

on UCITS hedge funds may be unnecessary and the

resulting performance drag of providing liquidity to

shorter-term investors may be too high.



Hedge fund fees

Towards a fairer deal

A changing dynamic

For a number of years, supply and demand

dynamics worked in favour of hedge fund

managers. Limited capacity led to rising hedge

fund fees and structures evolved with provisions

that skewed the alignment of interests between

investors and managers. Fee and fund term

negotiations were limited and many managers hid

behind Most Favoured Nation clauses which were

originally designed to protect investors, but which

became an excuse not to offer concessions.

The events of 2008 and the subsequent pressures

faced by many hedge funds led to a re-evaluation

of the value added by hedge funds and the way

that this is shared with investors. The terms

offered by many managers, as well as the

traditional 2+20 fee model came under scrutiny.

Investors providing sizeable allocations and with

a long-term investment horizon found themselves

in a position of considerable negotiating power.

We believe skilled managers should be rewarded

for alpha. We do not believe that cheaper is better,

but we do think that the combination of the hedge

funds fee and portfolio exposures (gross, net and

beta) should be structured to allow for a more

reasonable alpha split between the manager and

end investor. Given that investors place 100%

of their capital at risk, we view a two-thirds to

one-third split of alpha between investors and

managers respectively as an ideal division.

Here, we examine the structure of hedge fund fees

and terms and how these have evolved since thefinancial crisis. We believe that both are equally

important in achieving a structure that better

aligns the interests of funds with investors.

A. Types of hedge fund fee structure

Hedge fund fees usually consist of:

An annual management fee, and

A performance or incentive fee.

We believe structures that are well-aligned

should include:

Management fees that properly reflect theposition of the business.

Appropriate hurdle rates.

Non-resetting high watermarks

(known as a loss carry-forward provision).

Extension of the performance fee

calculation period.

Clawback provisions.

Reasonable pass through expenses.

Hedge fund managers should be compensated

for their skill (alpha) and not for delivering

market returns (beta). The separation of alpha

and beta is complex, but in our view worthanalysing in detail. In the context of constructing

appropriate fee structures for hedge fund managers,

we base our estimates on assumptions of

expected alpha generation per 100% of gross

exposure. This is married with the forward-looking

estimate of gross and net exposures of the fund

to calculate a gross alpha expectation. Total fees

payable are then assessed as a proportion of

total gross alpha. We have a target level of about

30-40% of this alpha being paid to the manager.

01 Industry trends



Annual management fees

The management fee often set at 2% of assets

provides the manager with revenue to cover the

operating costs of the firm. In some large funds,

the management fees may form a significant

part of the managers profit. We would prefer tosee annual management fees aligned with the

operating costs of the firm, leaving the performance

fee for employee bonuses. Over the course of

2009, our managers reduced the management

fee to an average of 1.5%. We would ideally prefer

to see tiered management fee structures (on a

sliding scale) given that a firms operating costs

do not normally increase in line with assets under

management. We do, however, recognise that

there are some strategies where alpha generation

is reliant on growth in research resources or

significant ongoing technology investments.

Performance, or incentive, fees

Performance fees are usually calculated

as a percentage of the funds profits net of

management fees. The performance fee is

generally used to pay staff bonuses and equity

holders. Typically, hedge funds charge 20% of

returns as a performance fee, payable annually.

We believe historical performance fee structures

do not sufficiently align manager and investor

interests; managers share profits, but there is

often no mechanism for them to share losses so

there is an incentive to take excessive risk ratherthan targeting high long-term returns. Structures

that contain hurdles, high watermarks and those

that defer fees with the ability to claw back in the

event of subsequent drawdowns are preferable.

Where an investment vehicle is set up to liquidate

a portfolio, we would prefer to see no performance

fees charged.

Hurdle rates

The use of a hurdle rate signifies that a manager

will not charge a performance fee until performance

exceeds a pre-determined target. Using a hurdle

encourages a hedge fund manager to provide ahigher return than a traditional usually lower

risk investment.

A manager may employ a soft hurdle where

fees are charged on all returns if the hurdle rate

is cleared. Others use a hard hurdle, where fees

are only payable on returns above the hurdle rate.

We prefer fee structures that include appropriate

hurdle rates. These should reflect the level of

net market exposure of the fund, although in

practical terms sometimes this is difficult to

implement. A hurdle based on a risk-free ratecan be more workable.

High watermarks

A high watermark can be applied to the calculation

of the performance fees to limit the fees payable.

It prevents a manager from taking a performance

fee on the same level of gains more than once,

and means that a manager will only receiveperformance fees when an investment is worth

more than its previous highest value. Should the

value of an investment decline, the fund must

bring it back above the previous highest value

before it can charge further performance fees.

Some managers make use of modified high

watermarks such as an amortising high watermark,

which spreads any losses over the longer term,

enabling the manager to earn at least some of

the performance fees in the current period. With a

resetting high watermark, any losses are erased

after a defined period of time has elapsed meaningmanagers can charge fees again before reaching

previous peak value.

We prefer the use of traditional non-resetting

high watermarks to ensure performance fees

are not paid on the same investment gains

more than once. However, we acknowledge

that a period of earning no performance fees

can put tremendous pressure on a managers

business. This could lead to difficulties retaining

talented investment professionals, and create

an incentive to close the fund and simply start

another one. A well-structured, modified highwatermark provides managers with the resources

to reward their best-performing staff and enable

them to stay in business. An example of this type

of structure might be a reduced performance

fee until 250% of losses have been recovered.

Our fee analysis shows that, in many cases,

the comparative cost to investors is negligible.

Extending the performance fee

calculation period

The shorter the period over which performance

fees are calculated and paid to managers

the more the fee terms are skewed in themanagers favour. Consider a situation where the

performance fee is calculated and paid quarterly:

if the manager delivers a strong first quarter and

three subsequent periods of underperformance,

the manager would still be paid a performance

fee (at the end of the first quarter) despite

underperforming over the course of the year.

The investor nurses a loss for the year while

the manager enjoys a performance fee.

In seeking to extend the performance fee

calculation period with managers, we aim to

reduce the optionality of the performance fee to

a more balanced structure, aligning the payment

profiles of managers and investors during both

positive and negative return periods.



Clawback provisions

This provision allows investors to claw back

performance fees charged in previous periods

if performance subsequently reverses. It links

the fee to longer-term performance, not a single

year, and means that fees are paid on averageperformance over a longer period (of two to five

years) or at the end of a lock-up period.

Negotiating fee discounts

On the face of it, lower fees are preferable given

that they translate directly into higher net returns.

However, investors should be aware that negotiating

a disproportionately low management fee may

compromise the managers ability to execute its

strategy effectively. In addition, if an investor-specific

fee is meaningfully lower than that of other accounts,

the managers incentive structure may be distorted

with respect to the allocation of investments.A fee structure that is far below market levels

may also hamper the managers ability to retain

key investment professionals.

We believe that the terms offered by a hedge

fund manager are of equal importance as fees

in aligning the interests of the manager with

the investor, as we examine in Figure 03.

B. The terms offered by hedgefund managers

The main terms described in a hedge fundcontract are:

Transparency

Liquidity

Gates

Side pockets

Key man clauses

Initial lock periods.

Below is an explanation of each of these terms

and our views on how each could be negotiated

between the investor and the manager.

TransparencyHedge funds historically have offered less

transparency than traditional asset managers,

principally to retain any perceived informational

and analytical advantage. This has contributed

to a reputation of secrecy. While we have some

sympathy with this, the dynamic of the industry

has changed and managers must increasingly

respect the fiduciary reporting requirements of

institutional investors and their advisors.

The majority of hedge funds will now enter into

detailed discussions of the risks assumed and

significant positions within a fund, however,some continue to offer limited transparency.

We insist on an appropriate level of transparency

in researching and monitoring hedge fund

managers. This can be in the form of access to

key investment professionals as well as portfolio

transparency. Most managers are willing to offer

performance transparency but some are reluctantto offer full position data, which they consider to

be a trade secret. To improve transparency and

monitor risk more effectively we use a third-party

risk analytics provider that accesses portfolio

information via the administrator. This allows an

independent verification of holding and analysis

of the portfolio risk: exposure, sensitivities and

underlying instruments used can all be tracked,

and combinations of managers can be modelled.

Liquidity

Hedge funds typically offer monthly, quarterly

or annual liquidity, and ask investors to servea minimum period of notice for redemptions,

normally ranging from 30 to 180 days. We believe

the key concern here is that the liquidity of the

fund reflects the inherent liquidity of the underlying

portfolio. In addition, we insist that the majority of

redemption penalties be paid into the fund rather

than to the manager.

Gates

Gates exist to provide stability to the portfolio in

the event of a large number of redemptions at

one time. These can be applied to each investor,

or to the fund as a whole. Investor level gatescan help to mitigate the prisoners dilemma of

pre-emptive redemption requests being placed, as

was witnessed in late 2008. However, fund level

gates, when applied judiciously, can act as valuable

guards to investors interests, ensuring that they

are not left with the most illiquid assets. However,

a manager should first seek to match the liquidity

terms of the fund with the portfolio assets, rather

than rely on gates to protect the fund.

Side pockets

Some funds have side pocket provisions that allow

them to segregate certain illiquid assets. Sidepocket assets cannot be redeemed by investors

in the same way as others. In most cases it would

be disadvantageous to investors to liquidate the

assets before a particular date or development.

We believe that side pockets do serve a valuable

function as long as the legal documentation is

clear on how they are structured and there is

monitoring transparency. They should not be

used by managers as a way to segregate poorly

performing assets and improve the performance

of the fund, nor should fees be charged on them

for indefinite time periods, particularly if investorshave expressed their desire to redeem.

01 Industry trends


21/44



Scn twoStrategy review

Now that we have reviewed

some of the key structural

trends impacting the hedge fund

industry, we turn our attention to

hedge fund strategies. These, too,

are evolving and what was the case

just a few years ago may no longer

be the case today. In our strategy

review we examine some of the

individual strategies in-depth.

Not all hedge fund strategies represent attractive

investments. The method of access is also

tremendously important. In addition to the decision

of whether to invest in hedge funds and how much,

we believe that each individual hedge fund strategy

deserves detailed scrutiny. Here we explore three

different hedge fund strategies where we have

subtly different views:

Event-driven.We feel that there are a number

of interesting manager opportunities but that a

simple beta strategy is difficult to structure and

not necessarily additive in a portfolio context.

Managed futures.We feel that there are some

interesting manager opportunities, but that

a simple beta/semi-active strategy may also

complement a traditional port folio.

Active currency.We feel there are limited

interesting manager opportunities and that

broader macro strategies make more sense.

02 Strategy review



Event-driven strategies

A decorrelated opportunity set

The key investment driver of event-driven

strategies is identifying the mispricing of

assets due to events such as M&A or corporate

restructurings. Because the outcomes of many

of these events are not driven by economic

factors, many consider event-driven investments

to be decorrelated. A wide range of opportunities

can be contained under the event-driven headingand many hedge funds look to allocate to some

or all of these strategies from small niche

managers who focus on a particular strategy, to

large multi-strats or specialists within a particular

asset class who use event-driven opportunities to

complement relative value strategies.

Types of event-driven funds

Traditionally, event-driven strategies generally

fall into two categories: merger arbitrage and

distressed debt strategies. This has evolved

now event-driven funds target any perceived

mispricing resulting from corporate actions.

We classify three strategies under the

event-driven umbrella:

Merger/risk arbitrage

Distressed

Special situations.

Merger arbitrage: the originalevent-driven strategy

Merger arbitrage is a classic event-driven approach:investors traditionally bought the stock of a target

company and shorted the equity of the acquirer.

The theory is to exploit the difference between the

current trading price of a target before it is sold

at a premium, and punish a buyer who typically

overpays for the acquisition. The strategy has

evolved to use financial and strategic analysis

to determine the potential takeover price, as well

as the use of leverage to amplify returns, requiring

investment banking expertise to judge the likelihood

of successful deal execution. Some managersemploy M&A or management consulting experience

to examine the likelihood of third-party, unsolicited

or broken bids. Legal experts can also be an

attractive addition to an event team, to uncover

break risk and timing issues that could impact

spreads or deal closure.

Distressed investing: exploitingcomplex credit situations

Distressed debt focused strategies invest in a

wide range of bonds, bank debt or trade claims

of firms in distress. Hedge funds take a view as

to the likelihood of successful bankruptcy

procedures or agreements with creditors.

Traditionally distressed investors buy distressed

debt at what they perceive to be cheap valuations,

looking for the restructuring event to result in

them holding cash or a different security worth

far more than their original investment. This is

often an arduous process as it requires examining

the motivation of individual credit holders with

various payback priorities on a variety of debt

holdings across the capital structure. The skill

is the ability to source unique investmentopportunities (in litigations, claims resolution

situations, corporate restructurings and

liquidations), to correctly identify the fulcrum

02 Strategy review



security (the security that will gain the most from

the redistribution of the companys value in the

restructuring) and the ability to actively influence

the restructuring process.

Special situations: extracting valuefrom non-M&A corporate activity

Special situations strategists seek opportunities

in recapitalisations, spin-offs or carve-outs, using

valuation analysis and timing skills often derived

from corporate finance experience. This approach

can also be classified as events with hard catalyst

the catalyst being an episode that can unlock

value, or place stress on the companys balance

sheet. Typically, when a firm announces the

sale or spin-off of assets or units, the proceeds

are returned to shareholders in the form of

increased dividends, share buybacks (resulting in

improved valuations), or via improvement to the

balance sheet (which leads to longer-term share

price gains). Some funds are activist, aiming to

persuade company management to maximise

value for shareholders or creditors.

How to choose an event-driven fund

While the first step to investing in event-driven

strategies is to understand the strategies

themselves (as described above), the way

in which the strategy is accessed is also

important. A wide range of hedge funds

implement event-driven strategies: from broadmulti-strategy funds who look to time entry and

exit to each strategy; to credit specialists who

will implement distressed debt strategies at

the appropriate stage in the business cycle; to

dedicated single or multi-strategy event funds.

We note that each individual event strategy

tends to be cyclical and as such some of the

more niche players tend not to offer full cycle

investment opportunities.

In addition to selecting the type of fund to accessthese opportunities, size can also be important

on the one hand these strategies generally

require significant levels of fundamental analysis

and often have a litigation angle, and as such

can be resource intensive. On the other hand,

particularly in equity situations, capacity can be

constrained, as such picking a manager who is

large enough to employ a sufficiently resourced

and skilled team, whilst remaining nimble enough

to re-allocate capital and be selective in its stock

selection is critical.

Decorrelated returns

Given that the outcome of corporate events

is often not linked to economic conditions,

event-driven strategies can be a source of

idiosyncratic returns. For example the split of

assets in a liquidation situation is determined

purely in court and the outcome of M&A

transactions is often determined by regulators.

Additionally, for managers with the flexibility to

move in and out of event-driven, and between the

various strategies, there are different opportunities

available throughout a market cycle. In recessionary

environments, distressed investments in corporates

going through liquidations or restructurings can

provide attractive investment opportunities, while



in economic upswings strong balance sheets

and confident management can initiate mergers

or distributions of cash to shareholders and

equity event opportunities become an

attractive strategy.

Participation in upswings

In strong growth or low interest rate

environments, there is plenty of opportunity for

equity event strategies. Confident companies,

armed with cash, are often happy to engage

in takeover plays. It is sometimes a case of

eat or be eaten since those cash treasure

chests look attractive to potential predators

as well. At the same time, inexpensive funding

conditions encourage takeovers by private

equity firms or opportunistic strategic acquirers.

The result is a surge of M&A activity. Positiveeconomic periods also create opportunities for

corporate turnarounds and company managers

are more willing to take on strategic risks such

as innovative business strategies. Managers

skilled in exploiting equity event situations

can benefit from a range of events in this type

of environment. However, in more difficult

economic conditions, where there is limited

merger activity and less shareholder friendly

action, equity event strategies can struggle

to allocate capital. Additionally, in market

drawdowns and periods of risk aversionthese strategies tend to suffer.

Opportunities in recessionaryenvironments

In times of economic stress, where corporate

default rates increase and traditional debt

owners, and certain hedge funds, are forced to

exit positions at distressed prices, managers

who have skill in analysing and influencing

restructurings and liquidations can find very

attractive opportunities. The returns from

distressed investing have been highly attractiveover time, however the timing of allocating to

distressed is critical.

Is there a beta solution?

We feel active event-driven strategies have a

place in a broad hedge fund portfolio because

they are highly dependent on deep skills,

resources and analysis than cannot easily be

replicated. There are also a number of different

strategies, most of which can be successful in

any type of market. A number of event-driven

replication strategies exist that attempt to gain

cheap and simple exposure. For example, one

could create a merger arbitrage strategy that

looks to participate in all announced deals above

a certain size, equally risk weighted. However,

there are several reasons why we feel that it is

more appropriate to gain access through fully

active strategies at present. These include:

Idea generation is not solely based

on company announcements but on

understanding the profit motivations of

various stakeholders: credit owners,

shareholders and company management.

Idea implementation is spread over various

asset classes according to the fund managers

interpretation of corporate events. This requires

investment banking expertise (M&A, capital

markets), strong fundamental analysis, legal

knowledge (antitrust, takeover laws and

bankruptcy proceedings), and trading

experience (liquidity and pricing).

Investment horizons vary from investor toinvestor. In a simple merger arbitrage strategy,

the profits from buying the spread of a

takeover and holding it until deal completion

may be improved by trading in and out of the

investment idea, as the spread moves prior

to deal completion.

Strategy evolution: the growth of tools to take

advantage of corporate events.

Leverage used to amplify returns or finance

the trades can be used to varying degrees and

equity financing is often another tool used in

this regard. Idea implementation is executed

over multiple asset classes, meaning that

replicating this strategy via a passive model

is extremely difficult.

02 Strategy review



Conclusion

We view event-driven strategies as a differentiated

source of alpha and an important component

of a hedge fund portfolio. The skillset required

in managing these strategies requires not just

financial expertise, but also legal insight, a

differentiated sourcing network and negotiation

skills. Given that individual event-driven strategies

tend to be cyclical and each event strategy

requires different resources and skillsets, we

believe that funds that can time allocations to

events and dynamically adjust exposures over time

are the best way to access these opportunities.



Managed futures/systematic strategies

Does quant macro work?

Differentiation betweenmanaged futures andsystematic macro managers

Managed futures managers are quantitatively

driven, trend-following, hedge funds. They

use futures and currency forward contracts to

implement price-based quantitative models.

By contrast, systematic macro managers use

quantitative models that do not completely rely

on price-based signals. For instance, they might

include value models or relative value technical

models. Here, we answer questions about how

these strategies work, whether they add value

relative to fees and ultimately whether they merit

inclusion in a hedge fund portfolio.

Managed futures alpha versus beta

There are a wide variety of trend-following modelspursued by managed futures managers, these

are based on technical price indicators ranging

from simple moving average crossover

techniques (for example, two moving averages

with different time horizons cross, leading to a

trend signal) to much more complicated methods

based on up- to-the-minute academic thinking.

In practice, for the vast majority of managed

futures strategies there is a significant overlap

in the indicators used, which leads to a high

degree of correlation between managers. The

correlation between managed futures managers

is typically in excess of 0.6 (1 is complete

correlation). If this is true, then why not invest in

a simple, easily understandable, trend-following

model for a modest management fee? Several

such products exist already and are sometimes

termed alternative beta. In many cases, we

believe that a simple, low-cost trend-following

solution is a sensible choice when constructing

a hedge fund portfolio.

However, whilst the correlation between many

managed futures managers is high, there ismeaningful dispersion between the best and worst

performers. We believe that certain managers can

differentiate themselves significantly, particularly

through their systems, risk management, liquidity,

trading costs, research processes and importantly

capacity management. But in reality, do these

things actually increase value to investors?

Picking the best performer out of the managed

futures managers with assets in excess of

US$5 billion would have returned around 3 to 4%

a year more over the recent five year period from

2007 to 2011 than picking the poorest performer.(Notably, all managers in this investment strategy

have generated attractive absolute returns during

the period.) This suggests that managers are

applying different controls with different levels

of success to their models. So managed futures

funds are not clones, even if at least a portion of

the return of most managers could be accessed

simply and cheaply.

The classic rationale for the persistence of

trends relies on behavioural finance the herding

behaviour of investors. There is a vast array of

academic literature to back this up and the backtests for managed futures performance look

impressive. But the fact that there is dispersion in

the performance of managers is not sufficient to

02 Strategy review



merit investment in a fully active managed futures

fund. To merit fees above what are charged for a

simplistic beta alternative, the manager needs to

have fundamental beliefs and a genuine edge that

can lead to outperformance. Whilst the underlying

indicators used are important, there are severalother very important factors to consider when

assessing a manager.

Are trend strategies valuable in aportfolio of direct hedge funds?

If you believe in the herd instinct then

trend-following in some form may sound like

a plausible and attractive strategy. But it

should only be used in the portfolio context.

Historical managed futures returns are

uncorrelated to other hedge fund strategies

and other mainstream market betas, but couldwe not go through an extended period where

trend following or other systematic models do

not work? Of course we could! Indeed, the

choppy markets of 2011 were difficult for many

managers to navigate. The difficulties might also

stem from the increase in assets invested in

trend following strategies.

Systematic macro is there a betaalternative here?

It is slightly different for systematic macro

managers. There is significant overlap in the

underlying indicators here too, but there is also

a different mix of alternative betas (an example

would be currency carry or purchasing power

parity). Systematic macro managers are not clones

either, but you could build a portfolio of simple and

easily understandable alternative betas that go

some way to explaining the returns of a number

of the underlying models.

The fundamental justification for systematic macro

models is easier to make than for trend followers

identifying something that is undervalued seemsto make more sense than simply following a

positively sloped price trend. An analysis of the

underlying beta exposures of a systematic macro

manager is still important though. Of course, it

may be that the manager is generating returns

based purely on differentiated models.

Researching quantitative strategies

Finding a definitive edge in a managed futures or

systematic macro manager requires differentiated

manager research techniques. It involves

reviewing systems, speaking to traders, running

through quantitative models and understanding

quantitative research processes. Knowing if that

edge actually adds value is perhaps even harder.

It requires an understanding of why the model

should work, making sure that the research

processes are not biased and an understanding

of the reasons behind the risk controls and trading

techniques. After all that, there is still a probability

that the models simply do not achieve what is

claimed. In other words, after fees, they do not

beat a simple, easily understandable model.

In addition, we need to be sure that we receive

enough transparency on complex active

systematic processes before we get comfortable

with them. This means transparency in several

respects: meeting researchers and traders,

understanding model examples, viewing systems

and infrastructure.

There are few managers in this category that

can generate sufficient risk-adjusted returns

as a result of an edge in model building, model

evolution, trading, risk management and systems.

A fork in the roadOur research into managed futures and

systematic macro managers has led us down

two paths. First, the significant overlap between

the models used leads us to favour simple,

low-cost, transparent quantitative models that

employ active risk control, strong systems and

a thoughtfully designed trading platform. We

would term this a semi-active alternative beta

solution. Second, sometimes the fees associated

with certain fully active systematic managers are

justifiable, but there has to be clear evidence of

an edge as well as appropriate transparency.


30/44



positive returns over time. Some of the most

common examples are the carry trade

(based on holding a basket of high yielding

currencies, funded by lower yielding currencies),

trend-following (for example, based on simple

moving average crossover techniques) and value(for example, based on a crude measure of

Purchasing Power Parity). If something is easy to

replicate and widely used, we do not think it merits

hedge fund fees. But can it be replicated?

There are few widely accepted indices following

currency investment strategies. The exception to

this is the carry trade, which has gained some

traction with index providers (for example, the

S&P Currency Arbitrage Index and the FTSE FRB10

Index). There are also several providers that offer

products in this area. The availability of widely-used

indices and investment strategies tracking thoseindices makes it easier to assess whether active

currency strategies are adding value.

Does active currency managementadd value?

Foreign exchange managers are often categorised

by the nature of the factors that drive their

investment decisions (technical versus fundamental,

for instance) and the way specific trade decisions

are taken (discretionary versus systematic).

Managers that focus on technical analysis usehistorical exchange-rate-based measures and

charting techniques in order to predict if a given

currency will appreciate or depreciate versus

another. At the other extreme, fundamentally-

driven managers focus on defining the fair value

of a currency based on economic measures.

With regard to the way trade decisions are taken,

systematic managers trades are driven by

rule-based models whereas discretionary

managers are driven by human decisions.

Currency managers normally offer active currency

products under active overlay programmes andstand-alone active products which are of ten

labelled as absolute return. Let us take a closer

look at these products and assess their merits.

Active overlay

Active overlay products are a mixture of a passive

approach to hedging a predetermined portion

of a portfolios foreign exchange exposure

and an absolute return currency management

programme. Under an active overlay programme,

the investor sets boundaries around the strategic

hedge ratio, within which the manager can take

active bets. These are of ten symmetrical so thatthe currency manager can express both bullish

and bearish views with regard to the foreign

currency. For example, a sterling-based investor

that has exposure to the US dollar may set up

a strategic hedge ratio of 50% with +/ 25%

maximum tactical deviation boundaries.

Active overlays are normally relatively inexpensive.

However, there are caveats: unless structured

carefully with appropriate risk limits, active overlay

mandates can represent a significant portion of

the active risk in a given portfolio. In addition,

most active overlay programmes are limited to

the foreign currencies to which the investor is

exposed. Yet, often, the manager is assigned to

manage only a small number of currency pairs (for

example GBP/EUR and GBP/USD). This results in

a somewhat paradoxical situation. If the investor

believes in the skill of the currency manager to add

return, then why limit the manager to only a few

currency pairs? As a result of these issues, we find

it difficult to be favourable towards active overlaymandates and our preferred recommended course

of action is passive currency hedging, according to

a carefully-chosen strategic hedge ratio.

Absolute return

Given the relative value nature of currency trades

and the use of leverage, we consider absolute

return currency strategies to be firmly in the hedge

fund camp. They tend to be liquid strategies and

relatively transparent and they also tend to have

hedge fund fee structures. However, we feel that

the vast majority of absolute return currency

products look at similar factors or indicators.Often, these are similar to the simplistic strategies

discussed above, suggesting that hedge fund fees

are unwarranted. However, we do recognise that

highly-skilled currency managers can generate

meaningful alpha. Even if they have an approach

based on a simplistic strategy, models can be

developed to have differentiating features. They

can also employ differentiated risk management

techniques, have superior trading and portfolio

management systems and be better informed on

liquidity and transaction costs.

Incorporate into a portfolio aspart of broader macro strategy

We recognise that there are a number of high

quality standalone active currency offerings.

However, due to the relatively narrow scope of

such strategies, it is unlikely (but not impossible)

for a dedicated currency manager to be part of a

concentrated portfolio of 10-15 direct managers.

In such a portfolio, we consider access to currency

skill through a broader macro or multi-strategy

hedge fund to be more appropriate.



Scn teHedge funds for less

03 Hedge funds for less



We have already talked about several simple alternative beta strategies in

our strategy reviews: they can provide low-cost and transparent access to

hedge fund-like return streams. There are also a number of other strategies

that are decorrelated to major market indices and yet can be accessed

outside of the hedge fund sector. This section looks at the investment

merits of some of these ideas and how they can be accessed.

Reinsurance.This strategy has low correlation to most other assets, but

is not for the faint-hearted. Investors collect healthy levels of premium for

long periods but then can suffer sudden large drawdowns. Over the long

term, the strategy has tended to pay off.

Emerging market currency.The long-term fundamentals for this strategy

are strong so paying active management fees is not necessarily the

sensible path for investors.

Volatility.This is an esoteric strategy that can be hard to fathom at first

sight. But it is worth persevering: accessing the risk premium in implied

volatility adds value to portfolios, reduces overall portfolio risk, but is not

totally decorrelated from the principal asset classes.

While the theoretical argument for investing

in hedge funds is clear, fees can be high.

They act as a drag on portfolio performance,

particularly at a time when many assets have

low yields.



Alternative beta

An introduction

The wider range of liquid, market-traded

instruments available today broadens the range

of alternative return drivers that sophisticated

institutions can access. As markets become

more commoditised and transparent, it becomes

possible to implement strategic allocations to

these drivers in a more systemic way than through

traditional hedge funds. Investment opportunities

and risk premia that were previously accessible

only through hedge funds, can now be accessed

in a simple and cost-efficient way.

Many institutional investors have had exposure

to asset classes that we now call alternative

beta for a long time. In a traditional investment

model, portfolios are split between bonds,

equities and alternatives with the latter category

often including one or more fund of hedge funds

and/or direct exposure to hedge funds. Investors

would look at fund of hedge funds as a source

of broad portfolio diversification effectively a

one-stop shop for alternative and diversifying

assets and returns.

As the hedge fund industry developed,

investors started to analyse returns, strategies

and exposures in much more detail. Looking at

a cross-section of funds revealed a number of

commonalities across managers and highlighteda number of strategies that investors could

replicate themselves. The high level of fees of

funds of hedge fund structures was an obvious

motivation for a number of investors to seek

cheaper replication, or alternative betas.

To us, this appears to be part of a healthyevolutionary process. Hedge funds operate

at the cutting edge of financial market

innovation, continually exploring new asset

classes and trading strategies. Some of their

investment strategies are therefore temporary

or opportunistic in nature and some will end up

losing money. However, a range of investments

will be profitable over the longer term. New

strategies are publicised by practitioners and

academic researchers and are then tested by

a range of other investors. So volumes in that

market rise and the costs of access diminish.

Techniques and asset classes previously used

only by active managers become commoditised,

allowing sophisticated investors to allocate to

them directly.

We see no single, satisfactory definition of

alternative betas, particularly as the list keeps

evolving. In general terms, though, we think

about it as a rewarded risk factor that investors

can access through a buy-and-hold strategy or

a mechanistic trading strategy. In many

cases, alternative betas blur the difference

between passive and active management,

combining non-standard indices with a

degree of active management.

03 Hedge funds for less



Benefits of allocating toalternative betas

There is little question that alternative beta is

a valuable addition to investment portfolios

and that the diversification they provide willenhance portfolio efficiency.

Transparency and clarity of the risks taken are

indeed a big advantage for port folio construction.

As investors are able to understand the risks

that are being taken, they can gain greater

comfort in these asset classes and will be able

to allocate a bigger share of their por tfolio to

these risks than in the FoHF model. Another

incentive for allocating to alternative betas is cost

savings. Investors should pay alpha- like fees for

alpha returns and beta- like fees for beta returns.

As this implies, alternative beta tends to bemore expensive than conventional asset classes

but less expensive than active management

products. Lastly, many alternative betas are

implemented through liquid instruments so

helping to manage overall por tfolio liquidity.

The alternative betainvestment process

The process to research, approve and invest

in alternative beta differs significantly from the

hedge fund approach. The majority of our research

focuses on analysing the investment strategy anddeciding if there is truly a long-term risk premium

to be captured. We rely on a multitude of evidence

and checks as part of our due diligence for new

alternative betas. This involves discussions with

practitioners and academic researchers, as well

as detailed desk-based research using our own

analysis and back-testing of historic market data.

First, alternative betas need to be established

investment ideas that have been used by a

number of investment institutions for an extended

time period and have withstood the test of

time. There is typically a significant amount ofacademic and practitioner literature so we need

to be satisfied that increasing understanding of

and flows to the strategy do not eliminate return.

This is a key Litmus test that can help to filter out

arbitrage trades and opportunistic investments.

Second, it is important to understand the

economic source for a long-term, sustainable

return which is typically in exchange for taking on

a non-standard risk. In a number of cases returns

for alternative betas are driven by markets that are

structurally one-sided typically driven by demand

for hedging and risk management with no obvious

counterparty. In these cases, some institutions

are willing to pay a premium in exchange for a risk

reduction, while investors with no initial exposure

can take on some risk and earn the premium.

Third, there needs to be a suitable implementation

option. Given that the investment proposition is

likely to be new, it is often hard to define a clear

benchmark or index to follow. Considerable effort

is needed to define the investment strategy. In

some cases, this may include deciding between apurely mechanistic or passive implementation and

a semi-active implementation involving qualitative

judgement. Cost efficiency is an additional,

important requirement: most alternative beta

ideas use derivatives and the over-the-counter

market and thus require a more advanced

execution and trading capability than for traditional

asset classes. This often implies that alternative

betas are more expensive to implement than other

passive assets.

Compared to hedge funds, however, there

remain significant advantages with regards toimplementation. Alternative betas will rely less

on individual investment professionals and their

incentives, reducing the importance of identifying

skilled individuals and monitoring their behaviour.

Investment systems and infrastructure are

important for alternative betas but, compared

with hedge funds that require a best-in-class

infrastructure as part of their competitive

advantage, alternative beta requirements are

lower as execution intends to limit operational

risks rather than generate outperformance.

Ongoing monitoring is a relatively straightforwardprocess. But it is still important to monitor many

of the things we look for in active managers (such

as appropriate resource levels and normal levels

of team turnover) as well as to review the strategy

against its return expectations. Compared with

hedge funds, we expect the turnover of alternative

beta ideas and managers to be low.

So will alternative beta strategiesreplace hedge funds?

Using alternative betas in a portfolio raises the bar

for hedge funds. To prove their worth, hedge funds

need to show they can generate truly uncorrelated

alpha. This will involve a continuous process of

innovation, using newly developing asset classes

and focusing on trad

Documents

TW EU 2012 25068 Hedge Fund Investing Opportunities and Challenges