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...........Contributors in the next issue include:...............Dr. Steen Elhern, Ferguson Partners...........James Young, Thames River Capital.............Dr. James Muscat Azzopardi, Muscat Azzopardi & Associates............
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.

A Year of Crisis from July 2007 to June 2008: Have Hedge Funds Kept Their Absolute Return Promises?
Philippe Malaise, EDHEC Business School

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.)

The Birth of the Life Market
David Blake, Andrew Cairns and Kevin Dowd, The Pensions Institute, London


"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.)


Leading Article  
A Statement in Sheep's Clothing: Why Should Canada Care about FAS Statement 157?
James Loewen and Laura Macdonald, KPMG, Toronto

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.)

2008 Return Difference Between Small and Large Hedge Funds
Serge Berger, AlternativeSoft, New York

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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May 15......Investor Meet Manager Forum Bermuda
Apr 02............Independent Review Inc., Toronto
June 4..........Green Funds & Clean-Tech Investing
Q2 2009....Investor Meet Manager Forum, Toronto
Q2 2009....................Energy Conference, Dallas
Q3 2009.......Investor Meet Manager Forum, Dubai

Click here to read the press release from the
Clean-Tech & Renewable Energy Conference

Event News...

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


A Sunny Outlook for Clean Tech
Richard Goodman, Sandfire Securities Inc., Toronto

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.)
 

Airlines: A Play on Oil or a Real Investment Opportunity?
Dr. Fred Lazar, Schulich Scholl of Business, York University, Toronto


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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