Welcome to
Alternative
IQ, the
quarterly journal for the investment community.
Here you will find excerpts from some of
the articles contained in the latest Issue.
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A Year of Crisis from July 2007 to June 2008: Have Hedge
Funds Kept Their Absolute Return Promises?
Philippe Malaise, EDHEC Business School |
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The
financial crisis that began more than a year ago now, after
the sudden fall in the prices of investments backed by
sub-prime loans, sent shockwaves through the markets, with
unprecedented writedowns of asset values continuing to
undermine the foundations of the banking system and leading
to a pronounced economic slowdown. The great increase in
risk aversion ultimately led to great adjustments in the
stock markets. Since the initial falls in June 2007, the
major stock market indices have posted losses in the double
digits. Volatility has increased abruptly; in the first
quarter of 2008, it was twice its second-quarter 2007 low.
At the same time, credit spreads have widened greatly,
throwing high-yield bond indices into a free fall, while,
conversely, government bonds attracted renewed interest,
despite inflationary threats. In this environment, one of
instability, to say the least, analysis of the results
posted by the major alternative strategies since the summer
of 2007 takes on particular interest, all the more so in
that many hedge fund managers play up their ability to
withstand crises and to offer returns uncorrelated with
those of conventional asset classes.
The
results for the EDHEC alternative indices are mixed, but,
all in all, they are largely in line with expectations,
given the characteristics of each investment style. Although
some strategies have certainly profited from recent
turbulence in the capital markets, easily outperforming the
risk-free rate from July 2007 to June 2008, the majority
post less spectacular results, closer to zero and, in some
cases, they are even negative.
Of the
beneficiaries of this period of turbulence, short sellers
are by far the top performers (+24.82% from July 2007 to
June 2008). This performance is a result of their negative
beta (stock markets were in the red two of every three
months during these 12 months of activity). With a
cumulative return of +17.73% for the period, commodity
trading advisers (CTAs) have also done well. Short-term
funds managed to take advantage of increased market
volatility. For their part, trend followers, overall,
benefited from the September/October 2007 rebound then,
after having flipped their positions, from the bear markets
of January 2008. In addition, they profited amply from the
rise in commodity prices, the mid-February to mid-March fall
of the dollar, and changes in interest rate trends...
(To read the complete article, and the all others in Issue
#29, sign-up
here for a six-month free trial.)
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The Birth
of the Life Market
David Blake, Andrew Cairns and Kevin
Dowd, The Pensions Institute, London
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"By providing
financial protection against the major 18th and 19th
century risk of dying too soon, life assurance
became the biggest financial industry…providing
financial protection against the new risk of not
dying soon enough may well become the next century’s
major and most profitable financial industry."
Peter Drucker, The Economist, 1999.
1. Introduction
The life market,
the traded market in assets and liabilities linked
to longevity (or mortality), is the world’s newest
capital market. It has the potential to develop into
a very large global market indeed. This is because
of the growing recognition that longevity risk is a
huge risk that is proving to be highly burdensome to
those (corporations, governments and individuals)
who have to bear it. It cannot be hedged in existing
capital markets, and although it can be transferred
via insurance markets, these lack the capacity and
liquidity to support a fully-fledged traded market.
What is needed are new financial instruments,
together with the technology and tools to create a
liquid market. These conditions are just starting to
emerge, as evidenced by the first publicly-announced
longevity derivative transaction between investment
bank JPMorgan and Lucida, a UK-based insurer, on 15
February 2008 (Loeys et al, 2007 and Lucida, 2008).
The traditional
method of transferring longevity risk is through
insurance and reinsurance contracts. A current
example of this is the market for bulk annuity
transfers and pension fund buy-outs in the UK. This
is a market between annuity providers, pension
funds, insurers and reinsurers. The market involves
the transfer of all risks, including longevity risk.
In this article,
we discuss the problem of longevity risk (section 2)
and review the traditional solution for dealing with
it (section 3). We then consider what the capital
markets need to develop (section 4). Next, we
consider the first generation of bond-based capital
market solutions that have been tried so far
(section 5). The lessons learned here have informed
the design of the second generation of
derivatives-based capital market solutions, although
barriers remain to further development (section 6).
Finally, we draw our conclusions (section 7).
2. Longevity risk
Life expectancy
has been increasing in almost all the countries of
the world.3 Figure 1 shows the experience for the
UK. Male life expectancy at 65 rose from 13 years in
1981 to nearly 17 years in 2005, or by around 1.1%
p.a. By contrast, female life expectancy at 65 rose
from 17 years in 1981 to 19.7 years in 2005, or by
around 0.6% p.a. Figure 2 shows that, in developed
countries, life expectancy at birth (for females)
has been increasing almost linearly at the rate of
nearly three months per year for more than 150
years.
Although
aggregate increases in life expectancy can place
burdens on both public and private defined benefit
(DB) pension systems, to name one example, they
would not necessarily do so if they were fully
anticipated. The pension systems could respond by
requiring participants to pay higher contributions
when they are working or by requiring them to work
longer. Pension plan members might not like either
prospect, but, separately or in combination, they
could be used to maintain the viability of pension
systems.
So, it is not
aggregate increases in life expectancy per se that
is challenging the viability of pension systems
almost everywhere. Rather, it is the uncertainty
surrounding these increases in life expectancy — as
a result of unanticipated changes in mortality rates
— that is the real problem. This is what is meant by
longevity risk. It is only recently that the
stochastic nature of mortality rate changes has
begun to be recognised. Figure 3 shows that
aggregate mortality rates (in this case those of
65-year-old English and Welsh men) have been
generally declining (in this case since the 1970s),
but that changes have an unpredictable element, not
only from one period to next, but also over the long
run.
A large number of
products in pensions and life assurance have
longevity as a key source of risk, DB pension plans
and annuities being important examples. These
products expose DB plan sponsors and annuity
providers to unanticipated changes over time in the
mortality rates of the relevant reference
populations.
To be more specific, annuity providers are exposed
to the risk that the mortality rates of annuitants
will fall at a faster rate than accounted for in
pricing and reserving calculations. Annuities are
commoditised products selling on the basis of price,
and profit margins have to be kept low in order to
gain market share. If the mortality assumption built
into the price of annuities turns out to be a gross
overestimate, this cuts straight into the profit
margins of annuity providers. Many life companies in
the UK – where more than half of the world’s life
annuities are sold — claim to lose money on their
annuity business or offer them only on the most
unfavourable terms. The same argument applies,
mutatis mutandis, to sponsors of DB pension plans.
Yet life annuities are a desirable component of
retirement income provision throughout the world:
they are the only financial instrument ever devised
capable of protecting against individual longevity
risk. Without them, pension plans would be unable to
perform their fundamental task of protecting
retirees from outliving their resources for however
long they live. There is a real danger that they
might disappear from the financial scene and, hence,
leave pension plan providers and members exposed to
aggregate longevity risk that cannot be hedged
effectively.
3. The traditional solution for dealing with
longevity risk
The traditional solution for dealing with the
longevity risk in an annuity book or DB pension plan
is to sell the liability via an insurance or
reinsurance contract. This is known as a bulk
annuity transfer or a pension fund buy-out. Bulk
annuity transfers have come under increasing
attention in the UK since 2006, and we will examine
the main types.
The most common type is a full buy-out. This is
usually implemented using a life assurer regulated
in the UK by the Financial Services Authority (FSA).
The procedure can be illustrated using the following
example...
(To read the complete article, and the all others in Issue
#29, sign-up
here for a six-month free trial.) |
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Leading Article |
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A Statement in Sheep's Clothing: Why Should Canada Care
about FAS Statement 157?
James Loewen and Laura Macdonald,
KPMG, Toronto |
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On 15 November 15 2007, an event took place in the US
that was of great interest to the financial community.
That was the day FAS Statement No. 157 (FAS 157) came
into effect. Issued by the Financial Accounting
Standards Board (FASB) 14 months earlier, FAS 157 is a
response to investor requests for more transparency
about the methods and information companies (including
hedge funds) use to measure fair value. They wanted to
know more about the quality of the underlying
information, and how fair value measurements affect
income and performance.
Prior to this statement, there were many interpretive
definitions of fair value. Guidance for applying those
definitions in US generally accepted accounting
principles (GAAP) were limited, even though there are
over 40 current accounting standards within US GAAP that
require fair value measurements. The inconsistencies
were viewed as a significant problem; therefore, the
FASB sought increased consistency and comparability in
fair value measurements and more disclosure about fair
value measurements.
Accelerating the purge of credit markets
The timing of FAS 157 was somewhat unfortunate. At a
time when the US credit crisis was rapidly escalating,
FAS 157 introduced more comprehensive fair value
measurement and disclosure standards, which hedge funds
and financial institutions such as banks and pension
funds had to apply to their portfolios of relatively
illiquid securities. In 2007, these institutions had
barely begun to plumb the depths to which securities had
truly fallen on the market. FAS 157 could be in the
position of forcing faster write-downs and accelerating
the purge of credit markets to one fell swoop. The
potential for problems caused some in the industry to
ask for a delay in implementing FAS 157, but their
request was not granted.
In the ensuing 14 months, more rounds of write-downs
have occurred. It is not possible to measure the role of
FAS 157 in these events without a great deal of study
and, in fact, it is not the purpose of this article.
That purpose is two-fold: first, to explain to Canadian
hedge fund managers why they should be interested in a
US accounting standard that does not currently apply to
them (unless they also report under US GAAP); and
second, to familiarise these managers with some of the
basic concepts in FAS 157 and identify the changes that
could soon be required under Canadian GAAP.
IASB likes what it sees
The reason why Canadian hedge fund managers should be
interested in FAS 157 is simple. The International
Accounting Standards Board (IASB) is considering some of
the concepts contained within FAS 157, and Canada is
committed to adopting International Financial Reporting
Standards (IFRS) by 2011 for publicly accountable
enterprises, which may include some hedge funds. Canada
has its own relatively recent standard, the Canadian
Institute of Chartered Accountants Handbook Section
3855, which became mandatory effective October 2006 and
designed to harmonise with US and international
standards at the time. However, FAS 157, which requires
more detailed disclosure, was released a month earlier
in September 2006, and the IASB likes what it sees.
Canada is likely to see a standard similar to FAS 157
within three years.
What does FAS 157 specify?
FAS 157 defines fair value, establishes a framework for
measuring fair value in US GAAP and expands disclosures
about fair value measurements. It applies only to fair
value measurements already required or permitted by
other accounting standards and is expected to increase
the consistency of those measurements. Changes to
current practice relate to the definition of fair value,
the methods used to measure fair value, and the expanded
disclosures about fair value measurements.
The definition of fair value in FAS 157 retains the
exchange price notion in earlier definitions of fair
value. The statement clarifies that the exchange price
is the price in an orderly transaction between market
participants to sell the asset or transfer the liability
in the most advantageous market for that asset or
liability. That hypothetical transaction is made at the
measurement date, and is considered from the perspective
of a market participant that holds the asset or owes the
liability. In other words, the definition focuses on the
price that would be received to sell the asset or paid
to transfer the liability (an exit price), not the price
that would be paid to acquire the asset or received to
assume the liability (an entry price). The ‘exit price’
concept is consistent with current guidance for
investment funds, but some of the specifics of how to
determine the exit price/fair value of certain
investments may require changes to a hedge fund’s
valuation practices or techniques, at the very least for
financial reporting purposes.
For example, FAS 157 eliminates the use of ‘blockage’
factors by broker-dealers and certain investment
companies that have been applying the American Institute
of Certified Public Accountants (AICPA) Audit and
Accounting Guide for Investment Companies. FAS 157 also
removes the prohibition against recognition of gains or
losses at the inception of derivative transactions whose
fair value is estimated by applying a model, as dictated
by Emerging Issues Task Force (EITF) guidance.
(To read the complete article, and the all others in Issue
#29, sign-up
here for a six-month free trial.) |
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2008 Return Difference
Between Small and Large Hedge Funds
Serge Berger, AlternativeSoft,
New York |
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As
we look back at the untamed securities markets that
defined the year 2008, we naturally have to ask
ourselves which asset classes performed the least
poorly. To do this, we used the user-friendly
AlternativeSoft software platform, which enabled us to
quickly and accurately run statistics on individual
funds, as well as on a group of hedge funds. To reach
our conclusions, we will not use statistical measures
like R-squared or t-statistics, but rather want to
provide the reader with some interesting statistics.
Using the AlternativeSoft ‘asset search’ function, we
divided the hedge fund universe into four buckets of
different asset under management (AUM) sizes:
1.
small; US$10–$100 million (average US$37 million), 4,654
funds in total;
2. mid-sized; US$101–$500 million (average US$232
million), 2,004 funds in total;
3. large; >US$500 million (average US$693 million), 787
funds in total; and
4. super-large; 10 largest hedge funds (average US$7,721
million).
In
the following two parts, we first summarise our findings
of how hedge funds with different sizes of AUM
performed. We found that ‘super-large’ funds outperform
other smaller funds by around 2.5% for the 10-month
period. Second, we dig a little deeper, and explain our
findings regarding the performance between four hedge
fund strategies. We found that ‘small’ funds outperform
‘medium’ and ‘large’ funds in all four strategies
analysed for the period January 2008 to October 2008, by
an average of 3%.
Did larger hedge funds outperform smaller ones from
January to October 2008?
Much media talk and, indeed, a meaningful part of hedge
fund allocations have, in recent years, focused on the
large hedge funds. We asked ourselves how the large
funds’ 2008 performance compared to that of their
smaller peers. Does size matter during a ‘market crash’?
The ‘super-large’ bucket outperformed the other three
AUM buckets (ie, small, medium and large) by an average
of 250 bps, from January to October 2008. To position
this in perspective, on an annualised three-year basis,
the 10 largest funds outperformed small, medium and
large funds by 650bps, 500bps, and 400bps respectively.
Hence, at first glance, the simple takeaway would be
that size does matter, ie, ‘super-large’ funds
outperform smaller funds.
We
conclude that from January to October 2008, the
‘super-large’ funds outperformed the other funds with
better relative returns and mostly better Sharpe Ratio.
How did hedge fund strategies perform across
different AUM segments?
To
find possible answers to this question, instead of
comparing the entire universe of hedge fund strategies,
we focused on four popular strategies; macro, equity
long/short, multi-strategy and commodity trading
advisers (CTA).
In
the hedge fund universe, from January to October 2008,
macro funds averaged +2.4% returns. Interestingly
enough, macro funds belonging in the ‘large’ bucket
averaged +0.31%, compared to small and medium funds with
+2.94% and +1.95% returns respectively (see Table 1).
One potential explanation for the lower returners for
‘large’ macro funds might be the increased complexity
involved in the unwinding of larger positions.
Looking at the equity long/short category, it was again
the ‘small’ bucket outperforming the ‘large’ and
‘medium’ buckets. The outperformance of ‘small’ versus
‘large’ was 100bps.
In
the multi-strategy category, the ‘medium’ bucket was the
clear underperformer and ‘small’ the best performer.
‘Small’ CTAs tended to be the leaders in this category.
‘Large’ CTAs underperformed by between 520bps and
180bps, compared to ‘small’ and ‘medium’ CTAs,
respectively.
Table 1: Small
vs large hedge funds across hedge fund strategies
Source:
AlternativeSoft, HFR, hedgefund.net; Lipper-TASS
(To read the complete
article, and the all others in Issue #29, sign-up
here
for a six-month free trial.)
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Event News... |
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Sovereign Wealth Funds Forum, London
Feb 24
Marketing & Client Servicing for Hedge Funds, New
York, Feb 24-25
The NMS Family Office Forum, Palm Beach, FL, Mar
08-11
CFA Institute/EDHEC Alternative Asset Allocation
Seminar, London, Mar 17-19 |
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A Sunny Outlook for
Clean Tech
Richard Goodman, Sandfire
Securities Inc.,
Toronto |
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Richard
Goodman is Managing Director, Investment Banking at
Sandfire Securities Inc. Richard has been advising
clients for over 15 years as a consultant, lawyer
and investment banker. He recently spoke as feature
speaker at the Clean Tech & Renewable Energy
Conference hosted by the Hedge Fund Hotel and ISI
Publications.
Some days, it
feels as though I am a victim of a really cruel
practical joke.
Last September,
Lehman Brothers went belly up. The IPO market
vanished. Market volatility soared. No one is
trading on fundamentals any more. And we are in a
recession unlike any since the Great Depression.
A few months
prior to these catastrophic events, I left my
employment at a boutique dealer in Toronto and
joined a group of talented and experienced
individuals to start a new investment bank, Sandfire
Securities Inc. We were extremely optimistic about
our prospects despite the reality that we were in
the midst of a bear market and a burgeoning
recession. On 10 October 2008, Sandfire officially
became the newest investment bank on the Street. As
they say, it’s all about… timing.
If the market
chaos wasn’t bad enough, pundit after pundit is
prophesying the eventual destruction of the clean
tech sector.
Oh, did I mention
that Sandfire’s core sector focus is clean tech?
Clean tech
doomsayers
The New York
Times recently declared ‘Winds shift for
renewable energy…’ and ‘Alternative Energy Suddenly
Faces Headwinds’. The Globe & Mail asked ‘Has
the Sun Set on Clean Tech?’ Are these merely kitschy
headlines, or is the market truly moving away from
greener pastures?
Detractors
suggest that the economic viability for solar and
wind are unsustainable. They claim that the global
fight to cure the economic crisis will come at the
expense of the fight against global warming. It is
difficult to disagree with the facts; currently,
biofuels, solar, wind and others are sustainable
only with substantial government subsidies. Add to
the mix, the sun doesn’t always shine, the wind
doesn’t always blow, the price of oil has retreated
significantly from its record levels, the credit
freeze has diminished available project capital, and
you have a compelling argument to suggest that clean
tech’s day in the sun is over.
The market has
pummelled just about every stock in a
sector-agnostic fashion, particularly those with
negative earnings. The clean tech sector is rampant
with early-stage companies with negative earnings
and a plethora of ‘me too’ wind and solar companies
that would be uneconomic but for government
subsidies. As a consequence, the drop in prices in
the clean tech sector was much steeper than in the
market as a whole.
Will history
repeat itself?
Given the current
economic collapse and the enormous drop in the price
of oil from its recent highs, some speculate that
clean tech is destined to depart from the general
consciousness, just as it did after the last global
crisis almost 30 years ago. In fact, today’s
situation has some uncanny similarities to events
that led to the first incarnation of clean tech in
the early 1980s: the rise of oil prices inspired
radical changes in consumption behaviour and fuelled
alternative energy initiatives.
Further, the
global economic collapse in 1981 precipitated a
collapse in the price of oil by 75%. Consumption
behaviour ultimately normalised to previous
purchasing habits and the alternative energy
initiatives all but disappeared. (Source: ‘Will the
Economic Crash Take Down Our Hopes For Clean
Energy?’ AlterNet.)
There are,
however, some crucial distinguishing factors
regarding today’s oil price retreat from the past.
For example, the fundamentals that drive the growth
of clean tech are as sound as ever. Second, there is
a strong political will to legislate and stimulate
green initiatives. Furthermore, critical mass has
already been established in alternative energy
investments. Importantly, clean tech has advanced
well beyond just wind and solar, and technical
innovation is moving at a rapid pace. Lastly,
corporations have finally discovered that adopting
clean technology can improve their bottom line.
(To read the
complete article, and the all others in Issue #29,
sign-up
here
for a six-month free trial.)
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Airlines: A Play on Oil or a Real Investment
Opportunity?
Dr.
Fred Lazar, Schulich Scholl of Business, York
University, Toronto |
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If we look at the airline industry over a long
period of time, and we include not only the
airlines, but also all of the suppliers to the
airlines — aircraft manufacturers, airports, ground
handling companies, IT firms, management
consultants, leasing companies, freight forwarders,
global distribution systems, engine and airframe
maintenance and repair organisations, flight
simulator manufacturers, pilot training companies
and air traffic control operators — we find an
industry with very attractive investment
characteristics.
The industry is
critical for the global economy. It connects people,
so it is important for business as well as tourism.
It moves freight, so it is important for world
trade, especially for time-sensitive products.
The total
revenues of the entire industry have grown more
rapidly than world GDP during each decade in the
past 50 years. Total revenues have rarely declined
from one year to the next.
The industry is
technologically advanced, from the engines, the
airframes, the IT systems and financial engineering
inherent in leasing. At one time, American Airlines
had the largest computer network outside the US
Pentagon.
Everyone in this
industry, with the exception of the airlines
themselves, seems to make profits
consistently. Indeed, tens of billions of dollars are
invested annually in this industry, whether it is
developing new airports or expanding existing ones,
or building new planes and engines, or creating new
software and acquiring new hardware, or training
pilots, flight attendants, mechanics and other
maintenance workers.
But for the
airlines, it is either feast or famine. Since the
deregulation of the US airline industry in 1978,
there is an ever-expanding graveyard filled with new
and old airlines. Almost every business model has
failed at one time or another.
Warren Buffett,
after his experience investing in US Airways, now
avoids this sector like the plague. He views
airlines as a black hole that devours investors and
their money.
Part of the
problem facing airlines is the legacy of regulation.
Yes, most countries have ‘deregulated’ this
industry, but it is still subject to countless
regulations. There are foreign ownership
restrictions, a throwback to the days when every
country believed that it needed its own flag
carrier. There are the bilateral treaties which
impose limitations on who can fly between cities in
different countries, how often they can fly and what
they can charge. Both Emirates and Etihad Airlines
want to provide daily service to Toronto, but are
prevented from doing so by the existing bilateral
treaties. And, of course, there are labour laws,
environmental laws, consumer protection laws,
pension laws, occupational health and safety laws,
product safety laws and the list goes on.
Governments have
also created an asymmetrical relationship between
airlines and airports, which strongly favours the
airports — not surprising, since there was money in
doing so for governments. The International Air
Transport Association (IATA), the lobbyist for all
the major world airlines, has been arguing for years
that this asymmetrical relationship greatly
threatens the viability of airlines and, thus, the
‘goose’ that lays the golden eggs for the airports.
So far, the IATA has had limited success in changing
the relationships and costs for the airlines...
(To read the complete
article, and the all others in Issue #28, sign-up
here
for a six-month free trial.) |
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