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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President's Working Group
Recommends Best Practices for US Hedge Fund Industry
By Keith T. Robinson & Derek B. Newman,
Dechert LLP, Hong Kong. |
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On 15
April 2008, two private sector committees established by the
US President’s Working Group (PWG) on Financial Markets —
the Asset Managers’ Committee and the Investors’ Committee —
released separate but complementary reports setting out
proposed sets of best practices for US hedge fund managers
and investors. The report by the Asset Managers’ Committee
is intended to set standards for hedge fund managers that
are designed to reduce systemic risk and foster investor
protection. The report by the Investors’ Committee, which is
divided into a ‘Fiduciary’s Guide’ and an ‘Investor’s
Guide’, is designed to set practice standards and guidelines
for fiduciaries and investors considering, or already
investing in, hedge funds on behalf of qualified individuals
and institutions. These reports, working together, are meant
to implement the PWG’s Principles and Guidelines Regarding
Private Pools of Capital, issued on 22 February 2007 (the
‘Principles and Guidelines’).
These
reports build on existing industry initiatives and draw upon
insights from both US and non-US professional associations,
financial services professionals and a wide range of
institutional investors. For example, the committees
consulted with the Managed Funds Association, Alternative
Investment Management Association, major accounting firms
and others during their drafting process. As such, many of
the recommendations are already practiced by well-managed US
and non-US hedge funds and sophisticated, diligent
investors. However, as highlighted below, some of the
recommendations involve novel and far-reaching practices
that exceed current industry standards. Some of these
recommendations may appear especially unfamiliar to non-US
managers, as they draw from the principles applicable to US
public companies and investment advisers.
In
addition, it is important to note that these best practice
recommendations are not binding and do not have the force of
law or regulation. Rather, these recommendations represent
the position that discipline on the part of all market
participants (ie, hedge fund managers, investors and
counterparties), not new regulations, is the most effective
means of protecting investors and guarding against systemic
risk. For example, in the Principles and Guidelines, the PWG
recognised that ‘in our market-based economy, market
discipline of risk-taking is the rule and government
regulation is the exception’, while a senior Treasury
Department official involved in the drafting of the
principles noted that any new regulations would discourage
innovation and risk-taking.
Nevertheless, despite the voluntary nature of these
recommendations, prior experience has shown that best
practice recommendations such as these ultimately may serve
as the basis for a subsequent legal and/or regulatory
framework. As the former Securities and Exchange Commission
(SEC) commissioner, Harvey J. Goldschmid, has warned, the
industry may only be ‘two serious scandals away’ from
vigorous legislation. Moreover, the standard of reasonable
practice for hedge fund managers applied for purposes of
regulatory or civil liability may change to reflect these
best practice standards if a sufficient number of hedge fund
managers ultimately implement the recommendations. Although
non-US investment managers may fall outside the scope of any
future US legal or regulatory framework, a strong market
impetus to follow these best practices may develop if the
reports have the intended effect of influencing investor
behaviour. The reports place significant emphasis on roles
of investors and counterparties, and pressure from these
parties to hold US and non-US managers to the best practice
recommendations may have an immediate impact on a manager’s
operations.
For
these reasons, US hedge fund managers and non-US managers
(particularly those that source US investors) should
carefully assess their specific practices against the
practices recommended by the committees. Managers that agree
to adopt these recommendations will face new compliance
challenges and costs, which may include the adoption and/or
revision of compliance procedures, revision of offering
documents and marketing materials and preparation of
periodic reports. Managers that do not disclose compliance
with the Managers’ Committee Report may incur legal
liability for failing to do so.
This article provides an overview of the best practice
recommendations and attempts to highlight areas where these
recommendations go above-and-beyond existing industry
standards. In addition, we briefly discuss the potential
global impact and applicability to non-US investment
managers, as well as implementation challenges.
Report of the Asset Managers’ Committee
The Asset Managers’ Committee is composed of a diverse group
of institutional alternative asset managers. The report by
the Asset Managers’ Committee recommends that managers adopt
a comprehensive framework, and related best practices, with
respect to five key areas: (1)
disclosure; (2) valuation; (3) risk management; (4) trading
and business operations; and (5) compliance and conflicts
of interest. The report acknowledges that the manner in
which each manager implements these recommendations will
differ in light of each manager’s size, strategies, products
and other salient characteristics of its business
(especially smaller managers, who may be unable to adopt all
the recommended practices, particularly while in their
inception phase).
(To read the complete article, and the all others in Issue
#27, sign-up
here for a six-month free trial.) |
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Leading Article |
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Liquidity Buckets,
Liquidity Indices,
Liquidity Durations and Their Applications to Hedge
Funds
By Ranjan Bhaduri & Christopher Art,
AlphaMetrix Alternative Investment Advisors, LLC,
Chicago. |
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Liquidity risk is the financial risk due to not being
able to pull one’s money out of an investment
instantaneously without market impact (ie, not having
perfect liquidity).
A
well-established fact from classical finance is that
investors expect a premium, or liquidity premium, for
investing in more illiquid assets [Damodaran 2002].
Hedge funds should not be exempt from providing a
liquidity premium and one should not mistake the
liquidity premium for alpha (Bhaduri, AllAboutAlpha
2007).
Mistaking illiquidity for alpha
Consider the following:
• Hedge Fund A has a two-year lock-up with annual
redemption and trades in illiquid instruments.
• Hedge Fund B has no lock-up with monthly redemption
and trades in liquid instruments.
• Both hedge funds have a five-year track year.
It is incorrect to merely compare the statistics
(return, volatility, skew, kurtosis, omega, etc) of
these two funds. Hedge Fund B allows the investor to get
out of the investment sooner and this has a value that
does not appear when one calculates the statistics. Due
to the illiquidity and lock-up, Hedge Fund A should be
furnishing a better statistical
return. One needs to quantify the value of liquidity in
order to make a fair statistical comparison. Otherwise,
it really is comparing apples to oranges. One should not
mistake the illiquidity of Hedge Fund A with alpha.
Portfolio managers must ensure that they are being
properly compensated to take on the illiquid assets.
Portfolio managers who do merely compare statistics of
Hedge Funds A and B are essentially giving the liquidity
premium a value of zero! While one knows (or should
know) that liquidity has a value, Bhaduri and Whelan
demonstrated via the Balls in the Hat game that it is
easy to underestimate the value of liquidity (Bhaduri &
Whelan 2008).
In
Emanuel Derman’s August 2006 paper ‘The Premium for
Hedge Fund Lock-ups’, he calculated that the risk
premium for a two-year lock-up over a one-year lock-up
is approximately 1% and approaches a constant of 3% for
longer lock ups (Derman 2006).
One may apply an option-pricing methodology into
portfolio management in order to try to take liquidity
differences into account (Krishnan & Nelken 2003 and
Whelan & Bhaduri 2008). However, these techniques,
though useful, can
sometimes be difficult to implement...
(To read the complete
article, and the all others in Issue #27, sign-up
here
for a six-month free trial.)
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Shari'ah-Compliant
Hedge Funds:
Commencing With First Principles
Michael J. T.
McMillen,
Fulbright & Jaworski LLP, New York.
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‘Alice laughed: ‘There’s no use trying,’ she said;
‘one can’t believe impossible things.’
‘I daresay you haven’t had much practice,’ said the
Queen. ‘When I was younger, I always did it for half an
hour a day. Why, sometimes I’ve believed as many as six
impossible things before breakfast.’ — Charles Lutwidge
Dodgson (Lewis Carroll), Alice in Wonderland.
Introduction and some initial considerations
Whenever, in response to inquiries as to my then-current
product development efforts, I replied that I was
working
on a hedge fund that was compliant with the principles
and precepts of Islamic Sharicah (the ‘Shari’ah’)1, the
immediate, usually unconsidered, response was, ‘it is
not possible under the Shari’ah; this is one type of
venture that
will be eternally absent from Islamic finance’. This
response stands in sharp contrast to the pervasive
admonition so
common in the Middle East that ‘all things are
possible’, which is often uttered with a tone that is
either immediately
contemplative or denotes a strong possibility of future
contemplation. The ‘not possible’ response was received
from
a broad range of business people, financiers, lawyers,
accountants and others involved in Islamic finance.
Importantly,
however, this has not been the response of the Shari’ah
scholars that will determine, ultimately, whether
Shari’ah-compliant hedge funds will be implemented (or, restated,
and presaging the analysis, when they will be
implemented)
and how hedging mechanisms used by Shari’ah-compliant
hedge funds will be structured. In fact, a limited
number
of Shari’ah-compliant hedging mechanisms have been
approved by prominent Shari’ah scholars for use by
Shari’ah-compliant hedge funds.
What is the basis for
the ‘impossibility’ response? Analytically, it must
relate to:
(a) some essential objective or characteristic of hedge
funds;
(b) the strategies used by hedge funds;
(c) the mechanisms used by hedge funds to conduct their
business; and/or
(d) the manner in which hedge funds are operated in
practice. This chapter will survey each of those bases.
Looking at the last basis first, it is clear that there
is some negative sentiment based upon publicity with
respect to the failures of, or misjudgments by, specific
hedge funds and to recent regulatory efforts directed at
hedge funds and fund managers. The concerns are
exacerbated by the increasing size of hedge funds, with
particular reference to the systemic effects of the
failure of a large hedge fund. Yet, the amount of money
under management has continued to increase dramatically,
now reaching approximately US$2 trillion, with the
fastest and most significant investor base growth being
institutional investors, such as pension funds,
endowments and foundations. The number of hedge funds
has increased to approximately 9,000. Clearly, a large
number of sophisticated investors perceive a positive
benefit in the existence and activities of hedge funds.
A survey of the popular press reveals recognition of the
fact that abuses and misjudgments are uncommon as a
relative matter. My discussions with those proclaiming
‘impossibility’ reinforce the assessment that their
response does not relate to these infrequencies or
related regulatory issues.
(To read the complete
article, and the all others in Issue #27, sign-up
here
for a six-month free trial.) |
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The Hedge Fund Hotel, Toronto
Seminars & Workshops~
Diary Dates!
For further information, contact:
Jeremy
Loeb on: 416.849.1913
jeremyl@isipublications.com
Sept 9....Setting up an Offshore Fund: Cayman
Islands
Sept 16..Hedge Funds Awards + IMM Forum (Toronto)
Nov 6............Investor Meet Manager Form (Geneva)
Oct 23................Risk Management for Hedge
Funds
Nov 13.........................Prime Brokerage
Services |
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Event News... |
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Canadian Hedge Funds Awards
Sept 16, Toronto, Canada.
High-Performance Investing Symposium
Sept 22, Monte Carlo, Monaco.
HEDGE 2008
Oct 22, London, UK
EDHEC Alternative Investment Days
Dec 9, London, UK. |
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Hedge Fund Legal
Structures and Their Impact on Performance
By Bhaswar Guphta and Edward
Szado, CISDM, Isenberg School of Management,
University of Massachusetts. |
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While there is a plethora of research on investment
strategies, asset allocation and risk management,
one area where academic research is scarce is the
legal structure that a fund employs and the
resulting differences in
performance and risk. Hedge funds may be set up
using a variety of legal structures and among the
more common ones are open-ended investment
companies, limited liability companies, partnerships
(3C1), partnerships (3C7) and corporations. This
article bridges the gap by examining performance
from the perspective of the legal structure of the
hedge fund. Using the Morningstar database, legal
structures are examined at the strategy level. A
probit model is formulated to examine whether or not
performance and level of assets are influenced by
the legal structure. The results show that while
there are no uniformly significant differences
between the performances and assets of funds using
various structures, certain patterns hold as to the
level
of assets and legal structures.
Introduction
The hedge funds industry has evolved tremendously in
recent years. According to the CASAM CISDM Industry
Report1, assets under management in hedge funds have
grown from less than US$50 billion at the end of
1990 to over US$2.2 trillion at the end of 2007.
Much of these flows have come from institutional
investors. According to Pensions & Investments
magazine2, direct hedge fund investments as of
September 2007 increased 67% from the year earlier,
while investments in fund of funds increased 38%
during that same period. With this asset flow, the
hedge fund industry has received increased scrutiny
in academic and practitioner research. While there
is a plethora of research on investment strategies,
asset allocation and risk management, one area where
academic research is scarce is the legal structure
that a fund employs and the resulting differences in
performance and risk. This article bridges the gap
by examining performance from the perspective of the
legal structure of the hedge fund.
The choice of
legal structure is certainly a critical decision.
The general partner may choose to set
himself/herself up as a limited liability company3
or corporation to limit personal liability. The
rules on such choices vary from state to state.
Offshore hedge funds are typically organised as
corporations in the respective domiciles (such as
the Bahamas, British Virgin Islands, etc). Offshore
funds generally manage assets of investors who
reside outside the US or the US tax-exempt
organisations. If managers wish to cater to both US
and non-US investors, a master-feeder structure may
be the structure of preference. The US investors in
a master-feeder fund typically invest in a domestic
feeder fund which may be a limited partnership fund.
The non-US and US-tax exempt investors generally
invest in an offshore feeder fund which may be
organised as a corporation. Both feeders invest
directly into the master fund. An alternative to the
master structure is a side-by-side structure or
parallel structure. In this type of structure, the
US investors typically invest in a limited
partnership organised in the US and offshore
investors invest in an offshore corporation. A major
disadvantage to this type of structure is that it is
more costly to operate and may not have as much
leveraging power, since the total assets are
separated into two pools. These different types of
structures raise numerous tax, legal and other
accounting and operational issues that are of
immense interest to academics, practitioners and
investors, but have only recently begun to be
addressed in the literature available.
(To read the
complete article, and the all others in Issue #27,
sign-up
here
for a six-month free trial.)
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Book Review... |
 Handbook
of Hedge
Funds
By
Francois-Serge
L'habitant
Reviewed by: John E. Dunn III
Oak Point Investments, Geneva. |
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Although Francois
Lhabitant’s Handbook of Hedge Funds was
originally published in 2006 and reprinted in 2007,
it is a timeless classic for anyone attempting to
understand the history, trading styles and
investment paradigms of the hedge fund industry. His
third book on hedge funds, the first title was a
compendium of the trading strategies and comments,
the second publication focused on quantitative
aspects of hedge fund evaluation and risk
management, and now this third book brings his
encyclopaedic knowledge together in one substantial
volume.
This title takes the reader through four very
captivating and important parts of the hedge fund
industry: first, a history of hedge funds since the
earliest references to hedge funds throughout the
decades, second, a review of the trading strategies
and characteristics of hedge funds, third, returns
and risk analysis, and fourth, a section addressing
how
and why to invest in hedge funds.
Lhabitant writes with an easily understandable style
for the layman. Although this encyclopaedic volume
is not strictly addressed to the layman reader, my
conclusion is that the ideal reading audience will
be broad: on one hand, junior and intermediate staff
working in the hedge fund industry desirous of
increasing their knowledge base and furthering their
career aspirations, and on the other hand,
intermediate and senior investment professionals who
desire to learn more about the hedge fund industry
as the institutions in which they work progressively
increase their hedge fund exposure.
(To read this
complete article,
click here.)
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