Due Diligence and Risk Assessment of an Alternative Investment Fund [1 ed.] 9783836635936, 9783836685931

Citation preview

Ingrid Vancas

Copyright © 2010. Diplomica Verlag. All rights reserved.

Due Diligence and Risk Assessment of an Alternative Investment Fund

Diplomica Verlag

Ingrid Vancas Due Diligence and Risk Assessment of an Alternative Investment Fund ISBN: 978-3-8366-3593-6 Herstellung: Diplomica® Verlag GmbH, Hamburg, 2010

Copyright © 2010. Diplomica Verlag. All rights reserved.

Dieses Werk ist urheberrechtlich geschützt. Die dadurch begründeten Rechte, insbesondere die der Übersetzung, des Nachdrucks, des Vortrags, der Entnahme von Abbildungen und Tabellen, der Funksendung, der Mikroverfilmung oder der Vervielfältigung auf anderen Wegen und der Speicherung in Datenverarbeitungsanlagen, bleiben, auch bei nur auszugsweiser Verwertung, vorbehalten. Eine Vervielfältigung dieses Werkes oder von Teilen dieses Werkes ist auch im Einzelfall nur in den Grenzen der gesetzlichen Bestimmungen des Urheberrechtsgesetzes der Bundesrepublik Deutschland in der jeweils geltenden Fassung zulässig. Sie ist grundsätzlich vergütungspflichtig. Zuwiderhandlungen unterliegen den Strafbestimmungen des Urheberrechtes. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. Die Informationen in diesem Werk wurden mit Sorgfalt erarbeitet. Dennoch können Fehler nicht vollständig ausgeschlossen werden und der Verlag, die Autoren oder Übersetzer übernehmen keine juristische Verantwortung oder irgendeine Haftung für evtl. verbliebene fehlerhafte Angaben und deren Folgen. © Diplomica Verlag GmbH http://www.diplomica-verlag.de, Hamburg 2010

Acknowledgments

The inspiration, the directory and the accomplishment of this book could not have been possible without encouraging conversations and consultation of several very special people, those who, I am grateful for their contribution. I would like to thank Michael Günther for providing me with a lot of useful material and books during the writing period. I have enjoyed our inspiring conversations and the time spent at Hedgework. This book could not have been accomplished without support from Prof. Dr. Jens Kleine to whom I would like to thank for encouraging me to delve into alternative funds industry. Many thanks to my old friend, Mats Nilsson, for his legendary “go for gold” saying, which always put a smile on my face and made me go an extra mile. Especially I would like to thank my friend, Andreas Hofmann, who gave me constant support and a steady stream of jokes. Also, many thanks for being around when I needed a break and spirited discussions.

Copyright © 2010. Diplomica Verlag. All rights reserved.

I am very grateful to Steve Lane, who provided the intellectual framework for my approach to understanding the risk. His knowledge, his experience and his fascinating personality impressed and inspired me over and over again.

Contents Contents ...................................................................................................................I Charts....................................................................................................................III Tables.................................................................................................................... IV Abbreviations..........................................................................................................V 1.

Agenda ............................................................................................................. 1 1.1 Introduction ............................................................................................... 1 1.2 Purpose and structure............................................................................... 2 1.3 Risk ............................................................................................................. 4 1.4 Alternative Investment Fund ................................................................... 6 1.5 Due Diligence ............................................................................................. 8

2.

Investment Philosophy and Due Diligence .................................................. 10 2.1 Investment policy, strategy and mandate ............................................. 10 2.2 Management team qualities ................................................................... 12 2.3 Performance screening of an Alternative Investment Fund ............... 18 2.4 Chapter sum up on the example of JWM Partners LLC.................... 22

3.

Relative Value and Market Neutral Strategy Risk....................................... 26 3.1 Relative Value and Market Neutral Strategy Risk .............................. 26 3.1.1 Fixed Income Arbitrage ....................................................................... 27 3.1.2 Convertible Arbitrage .......................................................................... 30 3.1.3 Equity Market Neutral ......................................................................... 31 3.2 Strategy Risk Level Aggregation ........................................................... 33

4.

Event Driven Strategy Risk ........................................................................... 35 4.1 Event Driven Strategy Risk.................................................................... 35 4.1.1 Risk Arbitrage...................................................................................... 36 4.1.2 Distressed Securities ............................................................................ 38 4.2 Strategy Risk Level Aggregation ........................................................... 41

Copyright © 2010. Diplomica Verlag. All rights reserved.

5.

Opportunistic Strategy Risk .......................................................................... 44 5.1 Opportunistic Strategy Risk................................................................... 44 5.1.1 Global Macro ....................................................................................... 45 5.1.2 Emerging Markets ............................................................................... 47 5.1.3 Long/Short Equity ............................................................................... 49 5.2 Strategy Risk Level Aggregation ........................................................... 51

I

6.

Internal and External Risk Factors .............................................................. 54 6.1 Internal Risks........................................................................................... 54 6.1.1 Hubris ................................................................................................... 54 6.1.2 The attitude, the structure and the business cycle risk ......................... 54 6.1.3 Operational risk .................................................................................... 56 6.1.4 The fund’s size, the funding and the leverage...................................... 58 6.1.5 Interpersonal relationship, transparency and reporting ........................ 60 6.2 Internal Risk Level Aggregation ............................................................ 60 6.3 External Risks .......................................................................................... 62 6.3.1 Industry shape, structure and evolution................................................ 62 6.3.2 Industry rivalry..................................................................................... 63 6.3.3 Trends and new strategies .................................................................... 65 6.3.4 Macroeconomic scenarios .................................................................... 66 6.3.5 Investment process and research .......................................................... 68 6.4 External Risk Level Aggregation ........................................................... 69

7.

Due Diligence framework, conclusive reflexion and closing remarks........ 70 7.1 Framework for assessing the fund’s risk profile .................................. 70 7.2 Case LTCM .............................................................................................. 71 7.3 Conclusive reflexion ................................................................................ 72 7.4 Closing remarks....................................................................................... 74

Copyright © 2010. Diplomica Verlag. All rights reserved.

Bibliography.......................................................................................................... 78

II

Charts

Copyright © 2010. Diplomica Verlag. All rights reserved.

Page Chart 1: Categorisation of Alternative Investment Fund styles .................. 7

III

Tables

Copyright © 2010. Diplomica Verlag. All rights reserved.

Page Table 1: Stocks & bonds asset allocation between June 1985 and June 1988............................................................................10 Table 2: Yale university risk-adjusted return comparisson of traditional and alternative asset classes ..................................12 Table 3: The management team assessment ..........................................15 Table 4: The management team evaluation .............................................17 Table 5: Statistical indicators and performance figures ............................20 Table 6: The risk-scoring table .................................................................21 Table 7: The track record analysis in a broader context...........................22 Table 8: JWM Partners LLC facts summary .............................................24 Table 9: Major risks in Fixed Income Arbitrage strategy...........................29 Table 10: Major risks in Convertible Arbitrage strategy ............................31 Table 11: Major risks in Equity Market Neutral strategy ...........................32 Table 12: Consistency check of major style specific risks ........................33 Table 13: The strategy specific risk-scoring table.....................................34 Table 14: Major risks in Risk Arbitrage strategy .......................................38 Table 15: Major risks in Distressed Securities strategy ............................40 Table 16: Consistency check of major style specific risks ........................42 Table 17: The strategy specific risk-scoring table.....................................42 Table 18: Major risks in Global Macro strategy ........................................46 Table 19: Major risks in Emerging Markets strategy.................................48 Table 20: Major risks in Long/Short Equity strategy .................................50 Table 21: Consistency check of major style specific risks ........................52 Table 22: The strategy specific risk-scoring table.....................................52 Table 23: Attitude, structure and business risk.........................................55 Table 24: The operational risk overview...................................................57 Table 25: Fund’s size, funding and leverage risk .....................................59 Table 26: Interpersonal relationship, transparency and reporting.............60 Table 27: The risk-scoring table for internal risks .....................................61 Table 28: Industry shape, structure and evolution....................................62 Table 29: The factors changing industry rivalry ........................................64 Table 30: Fund’s proposition and industry attractivness...........................65 Table 31: PEST factors affecting the strategy ..........................................67 Table 32: The macro scenario and its probability .....................................67 Table 33: Investment process and reasearch...........................................68 Table 34: The risk-scoring table for external risks ....................................69 Table 35: The framework for fund’s risk profile assesment ......................70 Table 36: The risk level categorization scale............................................71

IV

Abbreviations

Copyright © 2010. Diplomica Verlag. All rights reserved.

AIMA AIS Approx. AML AuM BBVA Bn Bp CDO CFO COO CV FTD FX HFRI HNWI IKB KfW KYC IT LLC LTCM m MBS NAV OTC PEST P&L REITs SEC S&L S&P SpA SLA Trn UCITS VaR VW y

Alternative Investment Management Association Limited Alternative Investment Strategies Approximately Anti-Money Laundry Assets under Management Banco Bilbao Vizcaya Argentaria Billion Basis Points Collateral Debt Obligation Chief Financial Officer Chief Operation Officer Curriculum Vitae Financial Times Deutschland Foreign Exchange Hedge Fund Research, Inc. High Net Worth Individual IKB Deutsche Industriebank Kreditanstalt für Wiederaufbau Know Your Customer Information Technology Limited Liability Company Long Term Capital Management Months Mortgage Backed Securities Net Asset Value Over the Counter Political, Economic, Social, Technological Profit & Loss Real Estate Investment Trusts Securities Exchange Commission Stop & Loss Standard & Poors Societa per Azioni Service Level Agreement Trillion Undertakings for Collective Investments in Transferable Securities Value at risk Volkswagen Years

V

1. Agenda 1.1 Introduction “There can be few fields of human endeavour in which history counts for so little as in the world of finance” John Kenneth Galbraith1 Alternative investment funds have been considered private pools attracting HNWI and endowments. The picture started changing after March 2000 when alternative investment funds stepped into the spotlight of investors’ interest. Institutional investors sought after an effective means of diversification to protect the capital from the falling equity markets and depressed bond yields. Many alternative investment funds became more mature, and put in place advanced investment processes, lower leverage, improved transparency and effective risk management to satisfy the increased selection standards of pension funds and large institutions.2 The industry has been growing at a double-digit pace since 2004, from approx. $970 billion to an estimated $1.9 trillion AuM by the end of 2007.3

Copyright © 2010. Diplomica Verlag. All rights reserved.

The picture dramatically changed in 2008. On March 16th 2008, JP Morgan Chase with the aid of Federal Treasury acquired Bear Stearns for $2 per share. Bear Stearns would have filed in for Chapter 11 in order to preserve Bear Stearns from the bankruptcy.4 The acquisition was consummated on May 30th 2008 at the price of $10 per share.5 Markets stabilised momentarily before the next greatly rescue in Europe took place. IKB needed a liquidity support of €10.5 billion, causing some worries, but not substantially jeopardizing financial markets.6 After being supported in a series of rescue actions since July 2007 by KfW, IKB was sold to US-based investment fund Lone Star as a part of state-backed restructuring plan in August 2008.7 On September 15th 2008 Lehman Brothers went bankrupt. A new era of rescue actions in the banking industry worldwide rolled the financial markets and amplified ongoing credit crisis.8 The combined banking failures around the globe in 2008 caused the worst market crash since the great depression 1930s. The world financial markets struggled, thus creating an untenable strain on alternative investments. Since then, the financial institutions, asset managers and investors´ have lost billions of dollars. While worldwide banks were provided with liquidity to sustain the business, asset managers 1

Cit. Ineichen, Alexander M. [2005]: The critique of pure alpha, UBS Warburg, p. 56

2

Cp. Strachman, Daniel A. [2007]: The Fundamentals of Hedge Fund Management, p. 16

3

Cp. Eisinger, Jesse [2008]: The Hedge Fund Collapse, Conde Nast Portfolio, December 2008/January 2009, p. 143

4

Cp. Ziemann, Peter [2008]: hartgeld.com/filesadmin/pdf/Ziemann_Wahrheit-Bear-Stearns-2-Apr-08.pdf

5

Cp. Wall Street Journal [2008]: http://online.wsj.com/article/SB120569598608739825.html?mod=hpp_us_inside_today

6

Cp. Die Welt [2008]: http://www.welt.de/finanzen/article2338879/Rund-9-Milliarden-Euro-Steuergeld-retten-die-IKB.html

7

Cp. DW-World [2008]: http://www.dw-world.de/dw/article/0,2144,3729574,00.html

8

Cp. Lehman Brothers [2008]: www.lehman.com/press/pdf_2008/091508_lbhi_chapter11_announce.pdf

1

experienced panic situations where investors constantly kept pulling out the money. The industry was hit by further deteriorating prices, lack of liquidity, even in usually liquid assets, and the mismatches in assets and liability positions, as capital outflow continued due to markets turmoil. In September 2008, investors redeemed $41 billion from the alternative investment sector, which is the largest monthly money outflow since experts began tracking the numbers. The financial crisis induced deleveraging of balance sheets and contraction of general credit. These conditions and further friction in the industry will force large number of funds to leave the business. In order to normalize the situation the industry regulation and fund fee structures will become an issue. As regulation changes going forward there will be tire competition and more transparency as the overall market changes to avoid the calamity that has fallen on itself over the last two years. Furthermore as disparities in the market continue and the overall structural changes will create inefficiencies in alternative investments going forward.9

Copyright © 2010. Diplomica Verlag. All rights reserved.

The fraud case charged against Bernard Madoff, money manager who had absconded more than approx. $30 billion under management was arrested on December 11th 2008 and accused of running a giant “Ponzi scheme”. A long list of Mandoff’s clients who were individually invested up to $7.5 billion with Madoff will according to data compiled by Bloomberg suffer approx. $50 billion loss. Astonishing about Madoff case was the fact that not only HNWI or endowments were affected but well-known financial institutions, asset managers and insurances that have also invested with Bernard Madoff. The list contains Banco Santander SA, BBVA, BNP Paribas SA, Dexia SA, Sumitomo Life Insurance Co, Nomura Holdings Inc, Societe Generale SA, Unicredit SpA, Pioneer Alternative Investments, Royal Bank of Canada, Clal Insurance, Nordea Bank AB, Man Group Plc to name some. Looking at the names there is a wide range of professionals in the financial services industry, who are presumed and supposed to have sound risk management practices as well as proper due diligence in place.10 General expectation is that the future alternative investment industry will change, but won’t disappear. There always will be investors willing to invest in skill-based strategy, preferring active money management. Due diligence and risk management is a crucial tool in helping to select the appropriate fund. It protects from fraud and helps selecting superior riskadjusted return provider. 1.2 Purpose and structure The focus of the book is the risk assessment and due diligence. It captures fund’s internal and external risk and the investment style specific risk. The aim is to provide sound guidance to alternative investment fund 9

Cp. Eisinger, Jesse [2008]: The Hedge Fund Collapse, Conde Nast Portfolio, December 2008/January 2009, pp. 142-145

10

Cp. Bloomberg [2008]: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=afAQU4E6gyA4

2

selection. UCITS 3 directive widens investment tools for traditional asset managers by allowing short selling of securities and diminishing the gap between traditional and alternative asset management industry and attracting traditional managers to the alternative investment universe.11 The importance of due diligence and fragmented risks analysis due to diversity of the investment styles is an essential point in the investment process.12 Unregulated offshore funds and Fund of Funds are not analysed. Offshore funds tend to have very limited restrictions on what they can do and usually their investment strategy is very vaguely explained in the fund prospectus. Regulated alternative investment funds tend to have very formalised maximum investment restrictions governing leverage and risk levels. Due to the fact that the alternative investment industry has its roots and longer history in USA as well as broader funds universe than in Europe or Asia, predominantly US funds examples are used. Commodity Trading Advisors and Private Equity Funds are substantial part of the Alternative Investment Funds Industry but are not in the scope this book. The author concentrates on the following three alternative investment fund categories: Relative Value and Market Neutral, Event Driven and Opportunistic. Whilst the industry is generally categorised into certain fund types it has to be stated that every fund is different and will have different risk attributes. Within the specific categories major risks will be the same, as the exposure towards the specific underlying will be similar. Still every single fund has to be examined on its own in detail, as it will have specific alpha generating competitive advantage, which is a return and a risk source.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Chapter 1 outlines the purpose and the structure of the book and the relevant definitions. Chapter 2 suggests preselecting of a potential fund manager or management team by analysing the team and the fund’s performance. The analysis goes through the quantitative figures and the qualities of the management team. Detailed knowledge about the strategy and its fit into the portfolio is worthless unless the investor is able to select the performing manager. Without that skill the probability of ending up with an underperforming alternative investment fund or a blow-up is huge. The management team quality analysis shows behaviour patterns helping to detect management teams tending towards moral hazard. The question investors seek to answer is who is the manager or the management team I intend to invest with? Chapters 3 to 5 handle alternative investment fund style specific risks. The author gives an overview over major risks per investment style. The specific investment style risk depending on the combination of major risks can be a warning sign about the future performance. The question 11

Prime, Didier / Carre, Olivier [2008]: Is UCITS 3 driving the convergence between hedge funds and long-only funds and what are the challenges?, AIMA Journal Summer 2008, pp. 1-3

12

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 11

3

investors seek to answer is what style specific risk level has the fund I intend to invest with? Chapter 6 examines fund’s internal and external risks. Thereby internal risks are directly connected to the management team and its operations. External risks are diverse outside factors influencing fund’s performance, e.g. industry and macroeconomic risks. Chapter 7 highlights the framework for the fund’s risk level assessment. It categorises risks based upon results commenced in previous chapters. Reflexive conclusions and closing remarks are represented at the end of the chapter 7. The alternative investment funds business is strongly driven by interpersonal relationships. It should be built on a strong, trustworthy relationship between investor or his advisor and the fund management. Even the best analysis based on historic data cannot fully capture behavioural changes nor can it reliably predict the future. It always should be complemented with human ability of logic thinking and reflexivity. "Nobody can predict the future, but you can understand the forces that will shape the future – and it is always better to play with forces than against them".13 1.3 Risk

Copyright © 2010. Diplomica Verlag. All rights reserved.

Financial perspective risk is defined and measured by the Value-at-Risk concept. It refers to the maximum potential loss, which can occur with a certain probability or confidence level during a certain period of time, e.g. one day, for a specified portfolio. The estimation is based on the volatility and correlations of daily securities´ returns within the specified portfolio.14 The position concentration and the size are effective risk indicators. The overall market liquidity and the single position liquidity as well as the counterparty exposure are monitored in order to quantify daily potential loss. Qualitative risks, i.e. operational risk or the business risk are evaluated as well.15 According to the modern portfolio theory risk is tightly connected to the return. The investor attempts to find the optimal portfolio’s risk-return profile. Markowitz theory is based on the assumption of a rational investor. The rational investor is only prepared to enter higher investment risk if it will deliver the appropriate higher return. A rational investor is seeking an efficient portfolio delivering the highest possible return at the lowest

13

Cit. Ruggles, Rudy / Holsthouse, Dan / Thurow, Lester [1999]: The Knowledge Advantage. In: Brainpower and the Future of Capitalism, p. 213

14 15

Cp. Choudhry, Moorad [2006]: An introduction to Value-at-Risk, p. 30 Cp. Cottier, Philipp Dr. [2000]: Hedge Funds and Managed Futures Performance, Risks, Strategies and Use in Investment Portfolios, pp. 48-49

4

acceptable risk level.16 Theoretically it is logical and seems to be a sufficient indicator for portfolio diversification and a return observation purposes. It is however insufficient or useless to indicate, explain or capture the market psychology. The market psychology refers to market participants’ perception of the future and the uncertainty off future events, which are the market prices drivers and the fundamental factor for an investment decision. George Soros presented an interesting hypothesis why relying on models gives a false sense of security of a factual at any point in time “unsafe” market. Knowledge based models are merely represented by statements assumed to be true. The validity of a statement is dependent upon its correlation to the facts. This correlation only can correctly function for the independent statements and facts, which refer to each other. As the investors are part of the markets and influence overall world happenings statements and facts are not independent of each other.17 “That is why participants cannot base their decisions on knowledge. What they lack in knowledge they have to make up for with guesswork based on experience, instinct, emotion, ritual, or other misconceptions. It is the participants´ biased views and misconceptions that introduce an element of uncertainty into the course of events.”18 Models do not capture the element of uncertainty inherent in social events, which more force us to rely on guesswork than knowledge. “I shall argue that, since social events have a different structure from natural phenomena, it was a mistake to model economics on Newtonian physics.”19

Copyright © 2010. Diplomica Verlag. All rights reserved.

The risk definition can also be put as the ability of being affected by something negative, which either makes us suffer personally, i.e. physically, emotionally or financially. The same ability and probability exists for the risk opposite, which we consider a chance or fortune. The word “risk” has its provenance from the early Italian word “risicare”, which means to venture or to take a chance on something. The action of taking a risk and suffering a loss can at the same time be the action of taking a chance and being rewarded. It is the question and the art of the risk management.20 Nassim N. Taleb illustrates the probability question of risk and chance in theory as well as in the real world in an interesting way. For decisionmaking we rely too often on the assumption of efficient markets, equation and mathematical models, which almost never correctly replicate the “real world” and even less our social behaviour. In the “real world” one has to guess the problem rather than predict the future based upon historic data modelling. Solving the problem is often a chance to higher rewards when 16

Cp. Peetz, Dietmar [2005]: Praktiker-Hanbuch Alternatives Investmentmanagement, p. 8

17

Cp. Soros, George [2008]: The New Paradigm for Financial Markets, p. 8

18

Cit. Soros, George [2008]: The New Paradigm for Financial Markets, p. 8

19

Cit. Soros, George [2008]: The New Paradigm for Financial Markets, p. 8

20

Cp. Bernstein, Peter L. [1998]: Against the gods, the remarkable story of risk, p. 8

5

one was “right” while the rest of the market was “wrong”. In an inefficient market guessing the problem or the origin of the inefficiency is the core of the strategic investment. Alternative investment funds are searching for market inefficiencies or mispricing using a special skill or advanced information to place the bet on the “right side” bearing chances rather than risks.21 In the strategy-focused investment process attempting absolute return risk is defined as a total risk. The opposite is a benchmark-driven investment process, defining risk as a tracking risk. Alternative investment funds consider total risk. They have proved sophisticated risk management during and post technology bubble as Brunnermeier and Nagel pointed out in their study.22 Managing the risk means reducing risk when the riskreturn opportunity set changes to the investor’s disadvantage.23 Or as Nicholas N. Taleb puts it: “Mild success can be explainable by skills and labour. Wild success is attribute to variance.”24 1.4 Alternative Investment Fund The origin of the term alternative investment fund stems from the first alternative fund managed by Alfred Winslow Jones founded in 1949. He managed a long equity fund and realised that he could only marginally outperform the index. Thus he established an investment partnership and raised a total of $100,000; thereof $40,000 was his own. To avoid the regulation under the Investment Company Act of 1940, which regulates the mutual funds with explicit rules, he limited himself to 99 investors in a limited partnership.

Copyright © 2010. Diplomica Verlag. All rights reserved.

In its first year the partnership gained 17.3% return on its capital. He went long strong stocks in certain industries and then shorted weaker stocks in the same industry, which meant that he should in a moving market outperform his benchmark index whilst in a downward market, should produce positive results. Stock picking was the nucleus of the discipline and short selling and leveraging the return booster regardless the direction of the market movement. Jones’s fund had outperformed the best mutual fund over the previous five years by 44%. On a ten year basis the fund had beaten the top performer Dreyfus Fund by 87%. Alfred Jones’s investors lost money in only 3 of 34 years. S&P500 had nine down years during the similar period of time. While the fund lost 35.3% during its worst year ending on 31st May 1970, S&P lost 23.4% over the same period. Alex Porter, one of portfolio managers, confirmed that fund’s market exposure was aggressive. Funds

21

Cp. Taleb, Nassim Nicholas [2005]: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, pp. x - xi

22

Cp. Brunnermeier, Markus K. / Nagel, Stefan [2004]: Hedge Funds and the Technology Bubble, In The Journal of Finance, Vol. Lix

23

Cp. Elgeti, Rolf / Mullane, Michael / Kreckel, Lars [2003]: AIS - Alternative Investment Strategies: Searching for the holy grail, p. 6

24

Cit. Taleb, Nassim Nicholas [2005]: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, p. 12

6

did perform better by being more conservative during the market downturn of 1973-1974.25 Chart 1 represents categorisation of the main alternative investment fund strategies in the way they will be analysed in the following chapters.26

Alternative Investment Fund Styles

Relative Value

Event Driven

Opportunistic

Fixed Income Arbitrage

Risk Arbitrage

Macro

Convertible Arbitrage

Distressed Securities

Emerging Markets

Equity Market Neutral

Long/Short Equity

Copyright © 2010. Diplomica Verlag. All rights reserved.

Source: In Search of Alpha [October 2000], UBS Warburg CHART 1: CATEGORISATION OF ALTERNATIVE INVESTMENT FUND

STYLES

The term alternative investment fund stems from the fact that they can provide alternative investment opportunities not provided by traditional non-leveraged mutual funds. The phrase covers a multitude of alternative investment funds. The aim is to generate above-average return in any kind of market environment. The managers’ special skill, the so-called “edge”, is essential. The intension is strategic positioning in order to explore alpha, instead of a benchmark replication.27 Stefano Lavinio subsumes alternative investment funds under a “skill-based strategies” due to their intense reliance on the managers’ skills.28

25

Cp. Economy point [2008]: http://www.economy-point.org/a/alfred-winslow-jones.html

26

Cp. UBS Warburg [2000]: In Search of Alpha, p. 20

27

Cp. Weber, Thomas [1999]: Das Einmaleins der Hedge Funds, Eine Einführung für Praktiker in hochentwicklelte Investmentstrategien, pp. 45-48

28

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 5

7

Due to their heterogeneity alternative investment funds are usually defined by their most common characteristics, which at the same time differentiate them towards mutual funds.29 In common literature they are mostly categorized in five trading disciplines; Long/Short Equity, Event Driven, Relative Value, Global Macro and Managed Futures.30 George Soros offered in “Open Society: Reforming Global Capitalism” an apposite definition. “Hedge funds engage in a variety of investment activities. They carter for sophisticated investors and are not subject to the regulations that apply to mutual funds geared toward the general public. The fund managers are compensated on the basis of performance rather than as a fixed percentage of assets. “Performance funds” would be a more accurate description.”31 1.5 Due Diligence Due diligence comprises the prudent evaluation of all possible transaction risks. The investor’s duty is to evaluate actual and potential risks involved in an investment as well as the duty of each party to confirm each other’s expectations and independently verify the abilities of the other to fulfil the requirements of the agreement. It covers broad range of business domains such as legal, tax, finance, business, human resources, culture, strategy and divestment.32 The aim is to evaluate the actual and the potential risk by screening information and thorough analysis of the investment domains. It can also be seen as the risk reduction process before the transaction conclusion and the capital preservation.

Copyright © 2010. Diplomica Verlag. All rights reserved.

EDHEC Risk and Asset Management Centre in Nice published in January 2007 a study on default risk due to operational processes. Quantification of 109 alternative investment funds defaults between 1994 and 2005 was conducted. The authors found out that operational risk, for which the investor receives no premium, is the most risky factor when investing in an alternative investment fund. In more than a half of alternative investment fund collapses, operational risk greatly exceeded the risk related to the investment strategy. The blow-up was directly related to a failure of one or several operational processes including fraud.33 The starting point of due diligence is the thorough analysis of a potential investment usually done by the investor himself. Information collection regarding investment, its quantitative and qualitative valuation as well as its pre and post investment control remains with the investor or his investment advisor. The aim is to reduce information asymmetry between the fund manager and the investor. Strategic aspects of an investment are 29

Cp. Friedrich, Markus / Bahr, Dietmar H. [2003]: Hedge Funds Die Königsklasse der Investments, p. 83

30

Cp. Schumm, Thomas / Lang, Roland [2004]: Hedge Fonds, Alles was Anleger über Investments und Risiken wissen müssen, pp. 66-98

31

Cit. Soros, George [2000]: Open Society: Reforming Global Capitalism, p. 83

32

Cp. businessdictonary [2008]: http://www.businessdictionary.com/definition/due-diligence.html

33

Cp. EDHEC Risk and Asset Management Research Centre [January 2007]: Quantification of Hedge Fund Default Risk, p. 4

8

important as well as the management team analysis. A comprehensive analysis of manager’s background will give the investor the ability to recognize how the manager is likely to act in a specific scenario. Systematic due diligence of the management team combined with the operational due diligence significantly reduces the potential risk of the investment.34

Copyright © 2010. Diplomica Verlag. All rights reserved.

Due diligence can also be seen as a powerful tool for the elimination of the problematic funds and a “natural” clearing up of the alternative investment industry. As problematic funds can be detected and excluded from capital allocation they can be squeezed out of the business. Due diligence is an appropriate tool for selecting the performance generators and eliminating the poor performers and defrauders thus cleaning up the industry and preserving the capital.

34

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 11

9

2. Investment Philosophy and Due Diligence 2.1 Investment policy, strategy and mandate “When all men think alike, no one thinks very much” Walter Lippmann35 The starting point of an investment decision is the analysis of the investor’s investment philosophy and his investment mandate. The framework for the portfolio construction is based on the expectations of return, spending levels, the asset class mix and markets to invest in.36 Investment returns stem from three tools of portfolio management, i.e. the asset allocation, the market timing and the security selection. These are combined with investors’ investment manners, which include a defined investment period, the investment philosophy and the investment policy. The asset allocation reflects the long-term investment decisions. That means the assets class mix and their percentage concentration of the overall portfolio assets, i.e. the portfolio composition.37 Market timing reflects the short-term portfolio rebalancing. Especially in extraordinary market conditions rebalancing should be used as a risk controlling and not as a return-enhancing tool. The market crash of 1987, showed the consequence of the market timing misuse as a tool for return enhancement instead of the risk controlling. Table 1 shows typical asset allocations between June 1985 and June 1988. Asset Allocation in % of portfolio assets

Stocks

Bonds

June 1985 (pre-crash year)

55.0%

36.9%

June 1987 (crash year)

55.3%

36.7%

June 1988 (post crash year)

49.1%

41.9%

Copyright © 2010. Diplomica Verlag. All rights reserved.

Source: Swensen, David F. [2000]: Pioneering Portfolio Management T A B L E 1 : S T O C K S & B O N D S A S S E T A L L O C A T I O N B E T W E E N J U N E 198 5 J U N E 198 8

AND

At that time equities outperformed fixed income by a margin of 70% to 25% for a two years period. As a result of reallocating more than 5% of assets from domestic stocks to bonds in the aftermath of 1987 crash institutional investors accepted significant opportunity costs as the market rendered a fairly rapid recovery. The bond and cash allocations remained 35

Cit. Ineichen, Alexander M. [2004]: European rainmakers, UBS Warburg, p. 64

36

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 52

37

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 57

10

above the pre-crash level until 1993. The uncontrolled tactical asset allocation to equity in the bullish stock market of 1980s let the equities drift above the desired levels and exposed portfolios to an excessive risk. The crash of 1987, forced the investors to lower the portfolio risk by commencing losses due to an excessive stock selling at the most inappropriate timing. In addition after the crash the equity reallocation in line with the long-term investment policy did not take place. The investors suffered opportunity costs as equities recovered fast and outperformed bonds. On an average, institutions bought assets high and sold low, as probably the most average investors trying to use timing as a return generator.38 Security selection represents the activity of the portfolio management. Either the manager replicates the market, which is a passive or benchmark oriented portfolio construction. Or he makes active bets constructing a portfolio, which differs from the composition of the overall market.39 The study “Determinants of Portfolio Performance II: An Update” commenced 1991 concludes that more than 90% of the portfolio performance stems from the allocation policy and less than 10% from the market timing and security selection.40 Consequently the investment policy and the portfolio construction are the starting point and the essence of the investment process from investors and fund managers perspective.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Portfolio diversification means that assets, which respond differently to the fundamental forces that drive the markets, are held. The alternative asset classes, which are not highly correlated to the domestic securities provide diversification and minimize the opportunity costs, i.e. investing in fixed income. Depending on the portfolio construction and the investment mandate they can be an opportunity for higher risk-adjusted returns among traditional asset classes while protecting the portfolio from an excessive drawdown in markets turmoil.41 The expected return, standard deviation and expected growth of eight asset classes are considered in Yale’s University quantitative model by using modified risk and return assumptions. According to Yale University greatest value in model optimisation is the use of a set of reasonable forecasts of expected relative returns for various asset classes. The historical capital markets data is manually adjusted for the variables; expected return, variance and correlation. The expected return and the variance are more important to the model than the less intuitive correlations.42

38

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, pp. 70-72

39

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 53

40

Cp. Brinson, Gary P. / Singer, Brian D. / Beebower, Gilbert L. [1991]: in Financial Analysts Journal 47, no. 3 , “Determinants of Portfolio Performance II: An Update”, pp. 40-48

41

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, pp. 64-66

42

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, pp. 109-112

11

Table 2 shows that alternative assets outperform traditional assets on the risk-adjusted base. U.S. Bonds

U.S. Equity

Developed Equity

Emerging Equity

Absolute Return

Real Estate

Private Equity

Cash

Expected Return

2%

6%

6%

8%

7%

4%

12.5%

0%

Standard Deviation

10

20

20

30

15

15

25

5

Expected Growth

1.5

4.1

4.1

3.9

6

2.9

9.8

0.1

Source: Swensen, David F. [2000]: Pioneering Portfolio Management TABLE 2: YALE UNIVERSITY RISK-ADJUSTED RETURN COMPARISON

OF

TRADITIONAL AND ALTERNATIVE ASSET CLASSES

The correlation matters whilst hedging downside risk in general and against the certain crisis scenario from which the investor seeks a protection. Secondly, the investor will look at the fund’s returns and strategy. And thirdly, the proportion of risk taken to generate the return or the maximum NAV volatility investor is prepared to bear. Eventually the investment mandate and policy restrictions will round up investor’s decision for or against a specific investment style. In order to justify such an investment the investor must believe that he can select a top-quartile manager. Otherwise, he won’t be properly compensated for the time, the effort and the riskiness of the investment.43 2.2 Management team qualities

Copyright © 2010. Diplomica Verlag. All rights reserved.

Warren Buffet’s formula on evaluating people is simple, but to the point. “In evaluating people, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you.”44 Subsequent important facts regarding the evaluation of the manager’s quality, loyalty and moral are discussed. The manager’s academic background and working experience are essential quality factors for the assessment of his basic skills. There is a remarkable difference in skill and experience in someone who has attended Harvard and worked for a prominent investment bank and afterwards managed a portfolio of a reputable alternative investment fund before setting up his own, and someone who has been an administrator with an investment bank or a research person at a no-name alternative investment fund and lacks the trading experience.45 The academic background and the appropriate practical experience, which matches the skill required for a certain strategy implementation is a necessity. 43

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 79

44

Cit. Ineichen, Alexander M. [2004]: European rainmakers, UBS Warburg, p. 110

45

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, pp. 254-255

12

Otherwise, the manager might provide good returns as a result of just being lucky and will sooner or later due to a randomness generate either huge loss or moderate and constant smaller losses as the return does not stem from the skill and the experience. A list of the former employers including a description of the responsibilities ought to be evaluated.46 The managers’ who rapidly change diverse positions in several or not related industries can be a warning sign. This type of manager will very likely not fit investor’s mid-term or long-term investment policy requirement to stick with the specific industry or the specific investment style. The origin of the inconsistency should be questioned. Secondly, it can indicate the manager’s poor performance. Not being one of the first quartile managers or ranging in the last quartile might force him to move from the one currently “hot” industry to another. This type of manager tries to capitalize on the cyclical upward move or a growing industry and shows temporary positive though not long-term competitive performance. The vast majority of such managers lack the “edge”, which becomes evident in a highly competitive environment. The likelihood of a brilliant mind that can in a short period of time switch the industries and adapt as a top performer is very low.47

Copyright © 2010. Diplomica Verlag. All rights reserved.

The manager who presents errors and misdeed in CV or even lies about his experience and the education is a red flag. His loyalty, accuracy and transparency are questioned. If someone is not accurate and willing to provide true information about the skill this person will most likely be inaccurate about the poor performance as well.48 A closer look at the entities that failed after the manager has left will disclose whether the entity failed because the manager, who left was a key performer or because he was the catalyst for the problems leaving before those became evident.49 The information presented in the prospectus should be complemented with the personal research from other sources such as publications about the manager or manager’s own publications. The level and the frequency of the positive or negative publications will portrait the personality and the skill. Questions can be discussed in a face-to-face meeting.50 Assigned or regulated funds grant an impression that their quality of the business set up is better than of an unregulated fund, as the fund has passed several checks before being registered and is obliged to transparency towards the regulatory body. The regulated funds have predominantly similar investor’s structure, as they are limited in terms of the type and the number of the investors that may be accepted. For

46

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 256

47

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 261

48

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, pp. 252-253

49

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 260

50

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, pp. 264-265

13

example, in the USA non-accredited investors are limited to a maximum of 35.51 An exceptionally important indication for the fund’s future performance can be the fact whether the fund is raising or losing money. In both cases the specific reason should be examined, as it will influence the fund’s size, its performance and the business set up. Additionally the manager might be forced to change or expand the strategy due to the money outflow or inflow. Depending on the skill of the management team the strategy changes or the team changes can be a potential red flag.

Copyright © 2010. Diplomica Verlag. All rights reserved.

A billion-dollar fund along with a complex strategy requires a properly connected working team within the fund. As soon as the teams are involved staffing problems appear. The compensation schemes, hierarchy structures or personal battles between employees arise. The complex internal structures involve personalities with different set of skills, as teams that will fit among each other are essential. On top the management team has to possess the ability to coordinate and manage several teams at once.52 A remarkable example of the winning teams was David Swensen´s Investments Office. David Swensen left Lehman Brothers to become the head of Yale’s Investment Office in 1985. His responsibility was to help Yale financing itself as well as teaching in Yale College. He built top performing Investment Office as he recruited and developed the high quality internal staff most of them being Yale graduates. The Investment Committee to which the Investment Office reported was composed of knowledgeable Yale alumni since most of them were active in different segments of the asset management business. The Committee was an in decision-making process actively involved board. It met quarterly and provided advice, counsel and approval of new investment managers. Such set up lead to a community exchanging facts and ideas in an uncomplicated way. A rigid organisation or hierarchies did not keep the Investment Office together since it was based on the perfectly matching teams, which corresponded inside themselves and in the interaction with other teams.53 People management involves a different set of skill than to manage only the capital. A manager should be able to explain where the strategy alpha will stem from and whether he has the appropriate set up to execute the strategy. A manager drifting away from the formerly formulated strategy is questionable in terms of loyalty and reliability. Such behaviour can indicate that the person is less trustworthy and might tend towards unethical practices. Returns generated through the changed instead of the originally promoted strategy will not charm the investors. Moreover if the manager is unable to explain the alpha origin of the changed strategy it is a clear red flag. The fund’s service providers can be indicators of its operational quality. A third party servicing the fund will arrange SLAs and fulfil due 51

Cp. Strachman, Daniel A. [2007]: The Fundamentals of Hedge Fund Management, pp. 8-9

52

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 258

53

Cp. Harvard Business School [2001]: Yale University Investments Office: July 2000, p. 3

14

diligence on its part of the cooperation before starting the business. A list of well-known third parties, i.e. prime broker, lawyer, accountant and administrator can be an indicator for the fund’s quality.54 Other source of information can be people who have left or recently started with the fund.55 Table 3 shows a list of questions and facts, which are the basis for the information collection about the management in order to evaluate the management team and detect potential red flags. The management team The management team composition 1. Who is involved in the fund’s management? 2. In which role and at what percentage of his time? 3. Who is having the management mandates outside the fund and what kind of mandates are those? The people / The team fit Does the team match and if necessary poses people management skill? The ownership structure and the organisation 1. What does the ownership structure and the company organisation look like? 2. The co-investments structure and the manager compensation scheme. 3. The fund should provide a chart of duties and responsibilities. The compliance set up 1. The responsibilities and duties segregation. 2. Can any current or potential conflict of interests be detected (i.e. legal, civil, administrative, taxation suits or any other)? The skill 1. Does the academic background, working experience and references prove required skill? 2. Does the manager change fast the industry and the investment style? 3. Can the manager explain the origin of alpha and is he able to manage risks? Legal violations Were there any criminal, civil or administrative proceedings against the firm or its managers or employees or are there any such matters pending (e.g. litigation, tax liens, law suits)? Character traits / Behaviour pattern 1. Is the fund raising or losing money? 2. Is the manager saying the truth? 3. Does the manager show hubris, lacks integrity and tend towards unethical behaviour?

Copyright © 2010. Diplomica Verlag. All rights reserved.

TABLE 3: THE

MANAGEMENT TEAM ASSESSMENT

The manager’s characteristics and traits are not directly connected to his skill and beneficially strategy execution but apply to his personality in general. That means, is he outside the business environment reliable and loyal or does he lack honesty and lies about nonrelevant details.56 A strong set of personal characteristics such as integrity and ethical behaviour codex improve the probability of an investment success and if they miss the manager can be a potential red flag.57 Thorough due 54

Cp. Strachman, Daniel A. [2007]: The Fundamentals of Hedge Fund Management, pp. 18-19

55

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 207

56

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 77

57

Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 253

15

diligence should include search after the specific patterns in the manager’s behaviour. If data analysis proves that certain behaviour, attitude or actions repeat again and again, i.e. a pattern is evident it displays a pretty accurate picture of the manager’s personal characteristics, which surely will affect his behaviour in the future.58 The management team should possess two essential qualitative characteristics, the specific strategy related skill and the risk management ability. The skill can be defined as manager’s ability to identify and capitalize on situations, which imply a high reward and a lower risk than assumed by the market. While the risk management can be defined as manager’s ability to cut losses and let winning positions run. The four dynamic components of any entrepreneurial process are the people, the opportunity, the external context and the way the involved business maker fit or the investment fit. The people are all individuals directly employed by the fund or its external service providers. The opportunity is the strategy, which is supposed to provide a superior return. The external context combines all factors, which influence the performance and are out of the direct management control, i.e. the regulatory changes, the changing market conditions, the changing industry or the macroeconomic factors. The investment fit refers to the complete set of the implicit and the explicit contractual relationships between the fund and the investor as well as the fund and its service providers.59 A face to face meeting with the management will round up due diligence and answer the outstanding questions. Another advantage of a personal meeting is that the investor can evaluate his impression of the management and the mutual “chemistry”. Before starting the due diligence process a list of questions and organised tasks, which will ensure the apt data collection, need to be in place. The thorough examination should answer following questions: 1. What do I know? 2. How relevant is the single fact for my investment decision?

Copyright © 2010. Diplomica Verlag. All rights reserved.

3. Does the data let me think and speculate or do I certainly know something, can prove it and know the facts?

58

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 77

59

Cp. Harvard Business School [1996]: Some Thoughts on Business Plans, p. 2

16

Table 4 shows a scoring matrix for the management team risk evaluation. Some risk factors can only be scored either with minimum or maximum points and some risk factors cannot be regarded as an average or high risk. Very Low 1 Management composition is very good and teams fit in overall fund’s structure

Low 2 Management composition is good, teams fit well, but not on overall level

Responsibilities/ duties are clearly segregated, no current or potential conflict of interest, ownership structure is entrepreneurial, coinvestments high

Responsibilities/ duties segregated, no current conflict of interest, ownership structure is entrepreneurial, co-investments mid to high

Top academic background, working experience and references, top risk manager, can explain strategy’s strengths and weaknesses

Very good academic background, working experience and references, above average risk manager, can explain strategy’s strengths and weaknesses

Average 3 Management composition is good and teams predominantly fit, but there is a room for improvement Responsibilities/ duties segregated, no current but potential conflict of interest, ownership structure is solely entrepreneurial, co-investments mid to low

High 4

Average academic background, working experience and references, average risk manager, can explain strategy

Poor academic background, low working experience and references, average risk manager, can explain strategy partly

Copyright © 2010. Diplomica Verlag. All rights reserved.

No criminal, civil, administrative proceedings against manager or employees Fund raising money, manager is trustworthy, no hubris/ lack of integrity or unethical behaviour

TABLE 4: THE

Fund loosing money, manager is trustworthy, no hubris/ lack of integrity or unethical behaviour

Fund raising/loosing money, manager is trustworthy but light touch of hubris

MANAGEMENT TEAM EVALUATION

17

Very high 5 Management composition is poor and teams don’t fit = red flag Partial segregation of responsibilities /duties, current & potential conflict of interests, ownership structure is short-term business oriented, low co-investments = red flag No academic background, low working experience and references, poor risk manager, can’t explain strategy = red flag

Criminal/civil/ administrative proceedings against manager or employees = red flag Manager is lying, hubris/ lack of integrity or unethical behaviour = red flag

2.3 Performance screening of an Alternative Investment Fund Stefano Lavinio outlines sound due diligence as a combination of a “detective” work, psychology and the keen industry insight. The starting point of a “detective” work should be the fund’s prospectus. Besides the basic information about the fund’s investment philosophy and the strategy, the management team and its track record prospectus should be screened for potential statements discrepancies. In general the aim is to get an idea about the fund’s investment strategy, the management team and whether the claimed statements are true and plausible. The management team assessment adds the psychology into the “game” and the keen industry insight combined with the previous two delivers a more accurate picture of the potential investment target.60 If the fund presents theoretical returns the investor has to bear in mind that theoretical returns do not represent the outcome of the management team’s investment actions. They only state what would have been the outcome within the theoretical composition of a certain methodology and assets class combination. Depending on the management’s background and skill this fact can be a red flag, as it does not represent the manager’s skill and the portfolio management ability in different market conditions. The likelihood that the manager won’t deliver promised return is potentially high especially among the strategies that are trading intensive. The historical track record is a reliable factor for the management team skill assessment at the same time the methodology used for the return calculation is critical. When comparing track records historical data has to be comparable one to one. The changes in the strategy, the investment style and the investment policy or the fee structure have to be considered. Moreover the investment style as well as the NAV calculation method has to be comparable.

Copyright © 2010. Diplomica Verlag. All rights reserved.

“Marked to spot” NAV calculation is based on assets spot prices. “Marked to model” represents the mathematical model for the asset price calculation. Both methods do not represent the true assets´ liquidation prices and a “Marked to spot” model is additionally not suitable for the evaluation of complex derivative products, as it can only capture onedimensional assets. A “Marked to market” model represents the true asset replacement price. It evaluates most accurately the NAV of liquid assets. A nonlliquid market along with less market participants able to set asset prices might provide a false incentive for the manager or other price providers to overvalue the assets. The pure NAV figures should be complemented by an examination of changes in the management team, the investment philosophy, the strategy or the policy, the fund’s leverage

60

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, pp. 19-22

18

and market conditions, e.g. fund did hold exposure towards volatile market or the investment strategy has been changed.61 An observation of the track record variation shows what portion of risk was undertaken to generate the return. An annualized standard deviation on a rolling basis for six months, one year, two, three, four and five years periods can provide a picture of the manager’s risk appetite. A substantial returns deviation disparity indicates changes in the fund, which are either internally or externally driven. The curve shape of returns illustrates whether the fund’s performance is negatively or positively skewed and is consistent or inconsistent in terms of height and volatility. In addition, the fat tails play a significant role, as they are the evidence for the fund’s high returns and great losses. The fund showing predominantly negatively skewed returns indicates the insufficient manager’s skill and can be a warning flag. The high standard deviation combined with high positive returns demonstrates strong skill, which adds value to the portfolio while negatively skewed returns even with a low standard deviation implicate lack of the skill.62 Such preliminary evaluation ensures that a fund showing potential red flags due to the manager’s personality, insufficient duty segregation or poor statistical figures can be eliminated on a basis of the selected criteria as the fund might bear higher in the future than currently anticipated. The manager’s track record, which shows high inconsistency, can indicate randomness rather than the skill based returns. If the returns imply to be market conditions favoured, the ultimate cause should be examined. The consistent and positively skewed returns solely are not predictable factors for the future performance estimation.

Copyright © 2010. Diplomica Verlag. All rights reserved.

If the management team composition has meanwhile changed, it will affect the future performance. Has the key personnel left the fund the future performance will not be as consistent as it was in the past unless the management has appropriately replaced the missing skill. The investor has to look at the past as well as at the future performance discontinuity.63

61

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, pp. 24-27

62

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, pp. 44-45

63

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, pp. 22-23

19

Table 5 shows the statistical indicators and the performance figures interpretation. Statistical indicators and performance figures interpretation Theoretical versus historical returns NAV calculation model / Marked to Track record dispersion Skewness

Only historical returns reflect real management investment actions Spot – spot price Model – calculated price Market - replacement price Analysis of the net return standard deviation on a rolling basis periods from 6m to 5y Negatively or positively skewed returns

Volatility

High or low returns volatility

Consistency

Consistent or inconsistent returns on a 5y data basis

Fat tails

The returns distribution in the fat tail areas

Drawdown 5 worst drawdown Negative months Recovery time

more than 10% of AuM in the past 5 years in the past 5 years in the past 5 years The portion of the return delivered in excess of volatility / risk assumed

Sharpe ratio

Copyright © 2010. Diplomica Verlag. All rights reserved.

TABLE 5: STATISTICAL

If theoretical track record is stated thorough analysis of manager’s skill and personality is essential NAV calculation model has to match the investment style, if not = a potential red flag Significant deviation changes indicate external or internal changes, which can be a hint for in-depth analysis of a potential red flag Negatively = indicator for poor track record or skill not matching the strategy Volatility = depending on investment mandate acceptable or a warning flag (i.e. if market exposure is not expected) The inconsistency can indicate randomness instead of skill = a red flag in a market neutral strategy Fat tails show great returns and excessive losses, depending on the investment mandate fat tails can be a red flag Drawdown > 10% 5 worst drawdown in % Number of negative months Number of months needed to recover Sharpe ratio = (Rp-Rf)/StdDev(p)

INDICATORS AND PERFORMANCE FIGURES

20

Table 6 is a risk-scoring matrix, which represents different risk levels. Scoring of the performance is only categorized in historical or theoretical performance, as those are from the rigours risk perspective the most relevant.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Very Low 1 Fund can represent historical performance Fund calculates NAV on basis of „marked to market“ model with „state of the art“ market data provider and evaluation practices. Pricing of nonliquid assets is reasonable and double checked with an independent price provider

Low 2

Average 3

High 4

Fund calculates NAV on basis of „marked to market“ model with sophisticated market data provider and evaluation practices. Pricing of nonliquid assets is only set by fund’s management but is reasonable

Fund calculates NAV on basis of „marked to market“ model. Market data provider and evaluation practices are reasonable but pricing of nonliquid assets is not/should not be done by fund’s management and other price providers in the market, as the incentive for inaccurate pricing is high Average performance, 3rd quartile fund

Fund calculates NAV on basis of „marked to model“ model or it’s „marked to market“ pricing is insufficiently set up

Mixture between positive and negative skewness, volatile standard deviation of returns Average performance, low to mid leverage, 3rd quartile fund

Less positive than negative returns, high standard deviation of returns

Very good performance, 1st quartile fund

Good performance, 2nd quartile fund

Predominantly and constantly positive skewness, low standard deviation of returns Very good performance, none or low leverage, 1st quartile fund

Predominantl y positive skewness, low standard deviation of returns

TABLE 6: THE

Good performance, none to low leverage, 2nd quartile fund

RISK-SCORING TABLE

21

Poor performance, 4th quartile fund

Poor performance, switching between mid and high leverage, 4th quartile fund

Very high 5 Fund can represent only theoretical performance Fund calculates NAV on basis of „marked to spot“ model. Pricing set up is insufficient and market data providers questionable

Very poor performance, fund should rethink its strategy Predominantly negative skewness, high standard deviation of returns Very poor performance, switching between mid and high leverage

The table 7 shows the track record in a broader context. It complements the final evaluation of the risk level classification, which certifies that the alpha stems from the management team skill and not from favourable external factors. The track record analysis in a broader context Did the management team change If yes, how did the team change? Did the key personnel left or joined the fund? Did the investment strategy, policy and philosophy change

If yes, how did the investment strategy change (e.g. style drift, additional styles, number of styles reduced)?

Did the fund’s leverage change

If yes, how did the leverage change?

Did the fund’s size change

If yes, how did the size change?

Did market conditions change

If yes, how did the market conditions change (e.g. volatility, regulation)?

Did the industry size change

If yes, how did the industry size change (e.g. more or less AuM, more funds, and the funds getting bigger or smaller)?

TABLE 7: THE

TRACK RECORD ANALYSIS IN A BROADER CONTEXT

Combining the observation of the management, the performance and the latest changes within the fund gives an impression of the management team behaviour throughout a certain period of time and within a certain market conditions. 2.4 Chapter sum up on the example of JWM Partners LLC

Copyright © 2010. Diplomica Verlag. All rights reserved.

As one of the managing partners John Meriwether blew up with LTCM in 1998.64 On December 15th 1999, he reopened new fund JWM Partners LLC, which started operating with AuM $250 million. At the beginning of 2008, John Meriwether managed approx. $2.3 billion AuM. The fund posted loss of 28% in 2008 after notching 5.6% return in 2007. The fund's average annualized return since inception was about 7%. According to Hedge Fund Research JWM's relative value strategy fund trails 9% average annualized gain of worldwide alternative investment funds during that period.65 Also his five-year-old JWM Global Macro Fund was down 6% through February after falling 5.6% in 2007. The fund has gained about 5.7% per year on average since it began trading in 2003. That means the macro fund too follows its peers, which have gained twice as much a year on average during the same period. JWM's losses have cut back the bond assets to less than $1 billion from the peak of more than $1.3 billion. The 64

Cp. Hoovers [2008]: http://www.hoovers.com/jwm-partners/--ID__61105--/free-co-profile.xhtml

65

Cp. Hf-implode [2008]: http://hf-implode.com/ailing/fund_JWMPartnersLLC-RelativeValueOpportunityfund_2008-03-27.html

22

macro fund has shrunk by at least half to about $350 million. The fund’s borrowing seems to be an issue too similar as it was with LTCM. The bond fund had $14.90 in borrowed money for every $1 in equity at the end of February 2008. Although far lower than at LTCM the fund's risk level was still far above the ground for the volatile environment and he acknowledged the leverage as a problem in conversations with investors. 66

John Meriwether marketed his bond fund as a lower-risk version of LTCM's core strategy, identifying the next financial crisis and profiting from it by buying securities considered underpriced. The investors were told that the firm would aim to keep the leverage below 15:1 even during the less volatile times. Additionally the firm promised the fund will behave more conservatively and will rebuild the reputation with the consistent returns.67 On February 4th 2009, Financial Times Deutschland reported that Mr. Meriwether plans to open a third fund. Meanwhile, his relative value strategy fund was down 42%.68 It seems that John Meriwether has not changed much about his strategy since the LTCM disaster. The fund has for a volatile market conditions kept too high leverage though the investors have been told the fund will behave conservatively. He and his management team run a relative value and opportunistic fund for which a different set of management skill is required. All funds do not perform better than their benchmarks and shadow the peers. The funds have lost value, as the management did not figure out the next financial crisis beforehand. Interesting is that some of the investors after LTCM invested again with JWM Funds, e.g. Deutsche Bank. One could presume that people learn from past experiences however behavioural tendencies tend to repeat on both sides the investors and the fund managers.69

Copyright © 2010. Diplomica Verlag. All rights reserved.

The investors who invested or reinvested with Mr. Meriwether have overseen the importance of comprehensive due diligence.70 The manager’s past can be an excellent predictor of his future actions. Even if the trading practice and the fund’s detailed investment strategy are not understood in detail knowing who the management team is, how it interacts and what a single manager has done before makes the investment decision more comfortable.71

66

Cp. Hf-implode [2008]: http://hf-implode.com/ailing/fund_JWMPartnersLLC-RelativeValueOpportunityfund_2008-03-27.html

67

Cp. Hf-implode [2008]: http://hf-implode.com/ailing/fund_JWMPartnersLLC-RelativeValueOpportunityfund_2008-03-27.html

68

Cp. FTD [2009]: http://www.ftd.de/koepfe/whoiswho/:Kopf-des-Tages-Comeback-des-Pleitiers-Meriwether/469738.html

69

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 29

70

Cp. Eisinger, Jesse [2008]: The Hedge Fund Collapse, Conde Nast Portfolio, December 2008/January 2009, p. 144

71

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 274

23

Table 8 is a summary of JWM Partners LLC Relative Value and Global Macro fund facts. JWM Partners LLC Relative Value and Global Macro Funds Mr. Meriwether was a managing partner at LTCM and blew up with the strategy in 1998 in a difficult economic environment. 10 years later Relative Value strategy is facing a crisis scenario, this time global credit crisis and a highly volatile markets JWM Relative Value Fund * An average annualized return approx. 7% since December 1999 while average annualized return of all relative value strategy funds was 9% for the same period * The return in 2008 was -28% and AuM less than $1bn while at the peak $ 1.3bn * The leverage of 14.90 : 1 was too high for an volatile market of 2008 and a falling interest rates environment * The strategy was marketed as a lower-risk version of LTCM, which turns out to be almost the same risk compared to the current market conditions (fund lost -42%) JWM Global Macro Fund * An average annualized return of 5.7% since 2003 while peers have returned 11.4% * The return in 2008 down by -6% and AuM shrunk by the half to $ 350million T A B L E 8 : JWM P A R T N E R S L LC

FACTS SUMMARY

A comprehensive due diligence provides not only assurance about the manager’s performance it also offers an insight into the management teams´ social structure and its background. It is crucial for an accurate predicting of the potential future behaviour.

Copyright © 2010. Diplomica Verlag. All rights reserved.

If the pattern of the management teams´ behaviour in a different market cycles or a crisis situations is known it enables the investor to detect a potential warnings on time and act before the management team actions turn disastrous. People will almost always exhibit their fundamental characteristics time and time again especially under the pressure. These specific characteristics point out how the management team is likely to act in particular scenarios. Systematic due diligence of the management team combined with the operational due diligence significantly reduces the blow-up risk.72 The development of products and investment strategies in a growing and maturing industry also attracts managers with scant track records. When 1997 less than 1.000 alternative investment funds run the business 2007 industry accounted for approx. 10.000 alternative investment funds. Obviously the selection process is getting more complex just by the increased number of the funds, the more complex products and a much higher rivalry within the industry. Selection of the top performing managers becomes a fiduciary duty before investing millions.73

72

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 11

73

Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 273

24

A comprehensive and thoroughly completed evaluation of the peoples´ characteristics should provide satisfying answers to the following questions.74 1. Who are the people involved? 2. What have they done in the past that would lead one to believe that they will be successful in the future? 3. If someone in the team is missing, who is it? 4. What is the nature of the opportunity, how will the fund make money?

Copyright © 2010. Diplomica Verlag. All rights reserved.

5. What contextual changes are likely to occur and how can management respond to those changes?

74

Cp. Harvard Business School [1996]: Some Thoughts on Business Plans, p. 27

25

3. Relative Value and Market Neutral Strategy Risk 3.1 Relative Value and Market Neutral Strategy Risk “An investment operation is one in which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Benjamin Graham75 Relative value and market neutral strategies are arbitrage trades in stocks, bonds, convertible bonds and subscription rights. The arbitrage represents the profit by capitalising on a temporary price difference of the same or correlating securities at different exchanges, i.e. assets moving away from their fair value or a historical norm. The investment strategy is based on the statistical and fundamental asset evaluation or a combination of both, e.g. pure quantitative models and algorithmic trading or a combination of statistical models and the fundamental securities analysis. In their plain structure both strategies are less correlated towards the securities markets than the Event Driven and the Opportunistic strategies.76 As the central part is realising the profit when assets converge to their fair value the fund seeks to hedge the alternative sources of potential return or risk, i.e. the exposure to foreign currencies, interest rates or broad market indices. To eliminate the risk of mispricing the fund holds long and short positions in the related securities.77

Copyright © 2010. Diplomica Verlag. All rights reserved.

In the efficient and less volatile markets there are fewer opportunities to generate alpha. As the manager won’t find the substantial price discrepancies spreads are low. The leverage increases the profit and the risk especially in an uncertain economic environment. Another alpha source is less liquid assets. Those bear an unexpected risk in the volatile markets or difficult economic periods.78 Though the generic strategy characteristics are avoidance of the direct long or short bias along with the consistent moderate returns and low volatility funds operating with the high leverage, errors in the historical market data or the quantitative model errors can be anything else than the low risk profile funds. Any flaw in the parameter assumptions or the market data can cause discrepancy between the actual and the perceived risk.79 Relative Value and Market Neutral strategies provide the net, excluding fee, average annual returns between 9.70% and 12.65% combined with a low annual standard deviation between 0.38% and 0.53%, which demonstrates the average expected risk/return profile of the strategy.80 If 75

Cit. Ineichen, Alexander M. [2004]: European rainmakers, UBS Investment Research, p. 4

76

Cp. Single, Gerhard L. [2001]: Boommarkt Hedge Funds - Initialzündung oder Strohfeuer am Europäischen Kapitalmarkt?, pp. 478-482

77

Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 22-23

78

Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 137

79

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 36

80

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

26

the fund is far out of the range the origin of the deviation has to be examined as the fund might bear unexpected risk due to the management team providing false information, IT or operational bugs or the fund taking far more excessive risks than expected within the strategy and the investment mandate. The investor must distinguish between the correlation and the exposure. For example, the fund can switch between short and long VW equity futures in such way that the correlation on average nets out. Thus, switching between the short and long future positions, on an average will show a net zero correlation towards VW equity. Although during the observed period of time fund was alternately exposed to the underlying risk by holding either long or short future positions. If the fund on average displays a zero correlation towards the market it does not necessarily mean that the fund at any point in time was not exposed to the market risk. The investor seeking portfolio diversification and a downside protection along with the constantly moderate returns and overall low volatility is looking for a “hedge” instead of an excessive market exposure, which is equal to an unexpected risk and is usually not corresponding to the investor’s mandate.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Relative Value and Market Neutral strategies can have an investment mandate to boost the return. In such case a higher volatility as well as market exposure have to be accepted and cannot be regarded as an unexpected risk.81 Prior to the investment the investor has to answer the question whether he is willing to accept a low, mid or high exposure. The specific strategy and the market exposure will influence fund’s risk profile especially in highly volatile markets. The liquidity of the underlying assets matters most when the fund’s leverage is excessive. In a crisis the liquid assets can turn nonliquid. The best-known example was the Russian crisis in 1998 when LTCM almost caused a systemic collapse. The highly leveraged fund held most of the positions in particular securities dominating the market. During the summer 1998, macroeconomic scenario dramatically changed as the liquidity in the underlying assets dried. The liquidity risk at times outweighed market risk in high-yield bonds, emerging markets and mortgage-backed securities. An actually from the plain strategy perspective low risk fund was due to its size, leverage and the positions size moving the market and almost caused a systemic collapse.82 3.1.1 Fixed Income Arbitrage Fixed income arbitrage strategies capitalise on the price disparities in the interest rate related assets and their derivatives through an establishment of the long and short positions. The manager should possess a deep asset pricing and quantitative modelling skill. The positions establishment and 81

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 17

82

Cp. Surowiecki, James [2004]: The Wisdom of Crowds, pp. 238-241

27

the strategy execution require profound mathematical and statistical knowledge as well as programming and data modelling skill. The essential skill is an accurate pricing of the fixed income assets as well as the estimation, the establishment and the adjustment of open and hedged positions. A quantitative insight, the risk management and the securities trading experience are the necessities in order to appropriate interpret the market movements. The aim is to detect temporary credit anomaly in the similar fixed income securities that are mathematically, fundamentally or historically interrelated.83 Alpha stems from the capitalization on disparities in the credit spreads, the yield curve movement on the maturity grids, the volatility spreads, the cash versus futures spreads, the counterparty rating changes and the special bond and option features, i.e. MBSs or CDOs, which offer a profit potential as long as many investors fail to explicitly value these.84

Copyright © 2010. Diplomica Verlag. All rights reserved.

Fixed Income Arbitrage strategy offers a net average annual return of 9.80% combined with an annual standard deviation of 0.68%.85 An example of the basic strategy would consist of long government bond position and a sold bond future contracts on the particular bond. Such construction automatically provides natural hedge though it is imperfect due to the unlike duration in future contract of three months and the bond up to 12 years interest rate movement sensitivity. The profit is expected from the disparity of the cheapest to delivery bond for the sold future contracts, as shifts in the demand and supply of the underlying bonds varies over the holding period. 86 In following different risks within the strategy are considered. The long or short bond positions entail the credit risk. In order to eliminate the credit default and the liquidity risk fund will trade in liquid issues usually government or corporate bonds although the fund is not constrained to such bonds and also can invest in junk bonds depending on the skill or the risk appetite. The changes in the interest rates or the yield curve structure involve market risk. As the long and short positions do not have the same duration and might not have the same interest paying character the interest rate risk is not perfectly hedged. This exposes the portfolio to the value changes along with the yield curve moves on the different interest rate grids. The liquidity risk can result in the increasing costs for the financing. As the borrowing becomes cheaper the financing costs for lending are expected to drop. If the financing profiles reverse the liquidity risk will arise. The legal risk can occur in taxation law changes. The extraordinary financial situations or political debacles can cause instability of the asset correlation, i.e. the derivative instruments and their underlying assets lose the stable correlation relationship and natural hedges break. The fund’s leverage is up to 30 times the fund’s equity. In a “normal” market conditions the spreads in fixed income assets are small ranging 83

Cp. Weber, Thomas [1999]: Das Einmaleins der Hedge Funds, pp. 76-79

84

Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 138

85

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

86

Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 28-30

28

between 3bp and 20bp. The normal market condition refers to low spreads for the credit risk premiums and not an inverse or flat yield curve. In the stable macroeconomic and political environment holding a credit spread risk equals the low credit risk while in market turmoil credit spreads widen and the fund’s positions depending on the bet can substantially lose money. The rare events largely influence the credit spreads. The high market volatility and a worsening credit risk perception are dangerous if the fund’s positions are not properly hedged. The exposure to a yield curve, FX rate or inter-market spread risk means that the fund is taking directional bets. Combined with a high leverage it can end up in a massive risk taking, which actually is not what the low risk appetite investor would expect within Relative Value strategy. 87 Table 9 shows major risks in Fixed Income Arbitrage strategy.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Major risks in Fixed Income Arbitrage Strategy The underlying risk (asset class / geographic market) Yield curves, FX rates, inter market spreads: changes in interest rates due to different positions maturity or interest rate payment character. Changes in the yield curve (steepening or inverse yield curve), FX rates and credit spread widening. The style risk Hedging Level: natural hedges versus perfect hedging. Depending on the hedging level the fund is exposed to market risk = what is the fund’s risk-return profile. Leverage: due to low spreads in the underlying assets usually highly leveraged = very risky if the manager skill is insufficient, hediging and rehedging is insufficient, positions size is too big in relation to other market participants, the underlying assets liquidity dries and the underlying assets are volatile or the markets in turmoil. The skill risk Essential Skill: the positions establishment in the interest rate products and their derivatives require strong pricing and quantitative modelling skill and hedging & rehedging of the positions. The market, credit, legal risk Exposure: can be very risky in combination with the leverage, the volatile markets and/or poor manager’s skill. Liquidity: drying underlying assets liquidity and increased financing cost as well as if the borrowed positions are more expensive than the lending costs. Volatility: if the fund holds market exposure, the hedging is insufficient = very risky. Credit: holding of bond positions with a different investment grades/rating (AAA versus Junk Bonds), the widening of the credit spreads in market turmoil. Legal: changes in the taxation law. Crisis scenario Any extraordinary market situation or political instability, which can cause high asset price deviations and break natural hedges, e.g. the underlying asset and its derivative instrument lose stable correlation relationship. TABLE 9: MAJOR

RISKS IN

FIXED INCOME ARBITRAGE

STRATEGY

Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for the funds style specific risk level scoring according to table 13. 87

Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 28-30

29

3.1.2 Convertible Arbitrage .

The strategy nucleus is the pricing of the convertible assets mostly bonds or preferred shares whilst hedging the market risks. Strategy execution involves a deep mathematical and statistical knowledge, programming and the data modelling skill. The essential skill is an accurate pricing of the fixed income assets as well as the estimation, the establishment and the adjustment of open and hedged positions. Quantitative insight, risk management and trading experience are essential in order to appropriately interpret market movements, i.e. a “feeling” for the traded security and the market volatility is crucial. Convertible bonds are hybrids between bonds and equities. The manager attempts to buy the undervalued bond, which can be converted into equity and hedges the specific risk by shorting the underlying equity.88 Though short equity position is a natural hedge as equities normally move inversely to the interest rates it still can be a risk if the asset correlation is low and the interest rates and the stocks raise parallel while the bonds fall.89 The strategy offers a net average annual return of 9.77% combined with a low annual standard deviation of 0.53%.90 This is in line with historically observed advantages of the strategy, which are market neutrality with a fairly stable return pattern and low correlations to bonds, equity and other hedge funds.

Copyright © 2010. Diplomica Verlag. All rights reserved.

A strategy example is a long bond position. The interest rate risk is hedged with an interest rate swap. As a natural hedge for long bond position equity is borrowed and sold short. The equity position can be delta neutral but must not as it depends on the hedge ratio. Gamma is usually left unhedged and the fund is long volatility, i.e. the stock price upward movement leads to outsized profits. Unhedged delta expresses the manager’s opinion on the future stock price, which is the rise in value. For hedging purposes warrants or options may be used instead or in addition to the stocks.91 The long bond position entails credit risk. The manager holds preferred instruments, which lowers the credit risk in case of the bankruptcy due to the seniority in repayment. Volatile stock and bond markets have negative impact on fund’s liquidity. When borrowing cost for the short sold equity raise or bond’s spread widens cash is needed to fund the costs. Preferability in dividends repayment and any regulatory constraint stated in the prospectus involves the legal risks. The fund’s leverage is up to ten times the equity. A stock volatility is a substantial risk if the fund is long delta and gamma and stock prices are moving opposite than expected. The assets liquidity and the accurate position hedging are essential, as 88

Cp. Cottier, Philipp [2000]: Hedge Funds and Managed Futures Performance, Risks, Strategies and Use in Investment Portfolios, p. 133

89

Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 25

90

Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 172

91

Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 161

30

liquid assets can turn nonliquid and induce higher risk than originally anticipated. Table 10 shows the major risks in Convertible Arbitrage Strategy. Major risks in Convertible Arbitrage Strategy The underlying risk Interest rates: low interest rates, which can negatively affect carry trades, the flat yield curve eliminates trade-off on the long and short end of the yield curve. The style risk Convertible issuing: a decline in issues leads to a poorer alternative investments trade off supply, thus the constant number of funds will compete in smaller industry, which will negatively affect returns and increase the operational risks. The source of alpha disappears as the underlying supply dries. Issue Calendar: changes in the new issues calendar are cyclical and can lead to a highly competitive market with a low number of issues as well as unfavourable issues, thus no pricing inefficiencies and substantial supply and demand changes offer a trade off. Greek risks: declining delta, gamma and vega and less opportunities & volatility to bet on. The skill risk Essential Skill: pricing, hedging and rehedging of open positions is very sensitive and includes careful monitoring on a daily basis, as depending on the hedge ratio and the leverage the fund can be highly exposed to the market risk. The market, credit, legal risk Exposure: unhedged equity positions. Liquidity: drying of underlying asset liquidity and liquidity shortage in order to fund the positions (a rising cost for the borrowed equity and widening bonds spreads). Volatility: declining volatility or a low volatility removes one of the alpha sources and lowers the returns, as gamma and sometimes delta risk are left unhedged. Credit: low credit risk due to the bond with preferability in repayment. Legal: changes in the repayment preferability or errors in the prospectus. Crisis scenario Market turmoil and bursting bubbles. T A B L E 10 : M A J O R

RISKS IN

CONVERTIBLE ARBITRAGE

STRATEGY

Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for the funds style specific risk level scoring according to table 13.

Copyright © 2010. Diplomica Verlag. All rights reserved.

3.1.3 Equity Market Neutral The aim is to detect arbitrage opportunities in the equities either by applying pairs trading or a statistical arbitrage. Consistent returns with low volatility and low correlation towards the equity or bond markets are the main strategy add-on.92 The statistical analysis of the historical market data designed for empirical conclusions, which are translated into the model and back-tested on validity, is the strategy nucleus. “Buy” and “Sell” portfolios of stock pairs often in the same industry, which tend to move in tandem, are generated. The short-term price discrepancy will in the long 92

Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 25

31

run return to the mean, which is the alpha origin in the long positions. Holding the appropriate short positions doubles the alpha.93 The statistical market data set and the quantitative modelling are the core skill of the strategy. The established long and short positions will provide a trade off due to deviating equity prices, which belong to the same economic entity and the same industry. The equity market neutral traders select hundreds of stocks in order to minimize the specific risk, neutralize portfolio beta and diversify the entity concentration risk. The statistical model, i.e. the assumptions and the historical market data are the greatest source of risk, as the constant resizing and beta adjustment is necessary. The second largest source of risk is the manager’s stock picking and evaluation ability, as he has to establish balanced portfolio of long and short stocks.94 Table 11 shows major risks in Equity Market Neutral strategy. Major risks in Equity Market Neutral Strategy

Copyright © 2010. Diplomica Verlag. All rights reserved.

The underlying risk Event risk: any event, merger or acquisition, regulatory or legal prosecution against the company increases stocks volatility. The substantial move in the stock price might not match the companies’ fundamental value during the event process. The style risk Model risk: A sudden flaw in the analytical model, i.e. the model suggests stocks upon historical stock specific and fundamental market data although the market participants behave opposite buying overvalued and selling undervalued equities. An example was the internet bubble when the internet stocks with no fundamental asset value and disproportionate growth in cash flow projections outperformed the blue chip companies with a substantial asset value. Value trap: the information asymmetry or psychological market conditions, which cannot be explained by the fundamental data. The established short positions are due to the fundamental valuation expected to gain value but instead they remain the same or even lose value. The skill risk Essential Skill: portfolio rebalancing, stock analysis, misidentification and stock picking in expectation of stocks to lose or gain value, the statistical modelling and the market data flaw. The market, credit, legal risk Exposure / entity concentration risk: it should be neutralized, if not it is a high risk and a potential red flag. Short squeezes: which cause massive specific stock price volatility in a shifting market towards a sellers market and drying the stocks liquidity. Crisis scenario Panics and bubbles bursting as well as any market condition where the fundamental valuation is overridden. T A B L E 11 : M A J O R

RISKS IN

EQUITY MARKET NEUTRAL

STRATEGY

Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for the funds style specific risk level scoring according to table 13. 93

Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 141

94

Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 138

32

Equity Market Neutral strategy provides net average annual return of 10.67% combined with a low annual standard deviation of 0.38%.95 The source of alpha in the long positions stems from selling overvalued and buying undervalued stocks. The second alpha source is the short positions trading book used for natural hedging of long positions. The stocks losing in value double the alpha. In the falling markets short positions normally gain more than the long lose. While if the markets go up long positions due to a superior stock selection gain more than the short positions lose. The third alpha source is the risk free rate in the Treasury bill, as cash from the short sold equity will be invested in the Treasury bill.96 The fund’s leverage is usually up to ten times the fund’s equity. 3.2 Strategy Risk Level Aggregation The major strategy risks analysis is verified through a consistency check. In general the analysis should start with an assessment of the strategy strengths and weaknesses as well as the internal and the external factors, which influence those positively or negatively. The evaluation of practical risks, which might emerge in or outside the fund includes the management, the concentration risk, the policy accuracy, the leverage, the skill, the hedging and the macroeconomic risk that is reflected in a crisis scenario. The combination of those factors should illustrate how the fund has performed in the past and will potentially in the future if the key variables do not change dramatically over the intended investment period. In following a general single strategy risk questionnaire and a scoring table reflecting the fund’s risk profile are represented.

Copyright © 2010. Diplomica Verlag. All rights reserved.

The table 12 shows plausibility check for the major single strategy risk evaluation before scoring the fund to a specific risk level. The consistency check of major style specific risks Can the management explain the exact strategy and the alpha origin? Can the management explain why the fund is different from the peers – the fund’s differentiation profile towards its peers is clear and plausible? What are the strengths and weaknesses of the strategy? Do the “skill” and the used instruments (futures, options…) match the strategy? Can the geographical market focus constrain the strategy execution? The portfolio concentration (the number of instruments and the exposure bias). The position limit problems (breach of limits, limits not sufficient). The hedging style and the level and how often is the portfolio rehedged? How is the rebalancing of the long-term policy done? The leverage in connection with the market liquidity and the fund’s market exposure. Is the leverage policy existent and followed? T A B L E 12 : C O N S I S T E N C Y

CHECK OF MAJOR STYLE SPECIFIC RISKS

95

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

96

Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, pp. 10-141

33

The fund’s risk can be scored according to the table 13. It illustrates the risk level categorization scale for the strategy specific risks. The risk level score

Very Low 1

Low 2

Average 3

High 4

Very high 5

The underlying risk The style risk The skill risk The market, credit, legal risk The risky crisis scenario and its probability T A B L E 13 : T H E

STRATEGY SPECIFIC RISK-SCORING TABLE

In general it can be stated that every fund is different and will have different risk attributes, which it makes difficult to think in categories and trivialise. The understanding of the business model, the alpha source, the strategy and the different types of risks the fund is taking is essential for its risk classification.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Highly volatile or by irrational behaviour driven markets bear extraordinary high risks for the fund’s return and the general strategy execution. Those factors are negatively amplified by a high leverage and when assets are turning from liquid to nonliquid at times. Thus the framework suggests to firstly analyse the underlying, the style, the skill, the market, the credit, the legal as well as other strategy specific risks. Secondly, before scoring the fund to a specific risk level the consistency check of the examined major strategy risks according to the table 12 has to be done. That means the plausibility check regarding the management, the strategy, the skill, the instruments, the hedging, the portfolio concentration, the limits, the investment policy and the leverage is necessary in order to see the full picture and how the risk components interact with each other. Relative Value strategies are often marketed as a low risk or even risk free though they are seldom risk free, as low spreads in efficient markets require considerable leverage and a position size in order to deliver an excess return. The historical assumptions are the second substantial risk source, as the basis is the yielding on aberrations from the historical patterns. The misleading data series and the heroic assumptions deliver false picture of the markets, thus the wrong basis for future predictions. Thirdly, the strategy is due to the leverage and the positions size extremely risk sensitive in volatile markets. The historic patterns might reverse their profile and if the fund is not perfectly hedged its positions and NAV will be affected by the price volatility. These might be the main reasons why within Relative Value strategies in a relation to other strategies seldom but spectacular blow-ups occurred.

34

4. Event Driven Strategy Risk 4.1 Event Driven Strategy Risk “We are ready for an unforeseen event that may or may not occur” Dan Quayle97 Event Driven strategies concentrate on for the most market participants unforeseen events that may or may not occur. The strategy foundation is a search after companies that are or may be a subject to restructuring, takeover, merger, liquidation or bankruptcy. It is the particular event that offers a trade off as well as a high risk of anticipating and pricing the event wrongly. The investment strategy is based on the fundamental company analysis including the assessment of legal and structural issues. The key risk factors in all Event Driven strategies are changes regarding structural, legal, financial, cultural or interpersonal negotiation dynamics during the event cycle. The management team has to collect, analyse and reflect all relevant information regarding the event and transfer it into the investment strategy. Being informed and up to date concerning the development and the ongoing event changes and company’s affairs is essential. Event Driven strategies are designed to realise the profit when the price of particular security changes as it reflects the probability of the upcoming event. The nucleus of the bet is the corporate event influencing stock’s valuation. In such an extraordinary event price movements are influenced by progressing extraordinary events and not on a basis of the company’s financial fundamentals. The accurate pricing of the event likelihood, i.e. the occurrence or non-occurrence of the anticipated or already publicly announced event is the “art” of the strategy.98

Copyright © 2010. Diplomica Verlag. All rights reserved.

Event Driven strategies provide an average annual returns between 9.80% and 14.50% combined with an annual standard deviation between 0.68% and 0.87%, which is in line with the expected risk/return profile of the fund.99 If the fund is far out of the range the investor should pay attention to it, as it might be an indicator for the potential unexpected risk.100 The exposure towards the equity market is present at all times, as the fund is holding long positions the securities volatility will influence portfolio value. In a crisis scenario when natural hedges are unstable, as asset correlations break and a broad range of markets lose value Event Driven strategies expose the portfolio to a higher market risk than initially anticipated. The asset liquidity plays a key role in the Event Driven and 97

Cit. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 33

98

Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 33

99

Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

100 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

35

Distressed Securities strategies. The price setting can be complicated and bid and ask prices can trade at a wide range spread. The fund’s performance should be evaluated in a macroeconomic context, which will validate whether the performance was generated as a result of the market volatility or skill. The investors looking for the return enhancement will have to verify their maximum exposure tolerance in a “normal” and a “highly” volatile market conditions.101 4.1.1 Risk Arbitrage Major risk is the prediction of the event’s probability and the deals finally taking place. When mergers or acquisitions are announced the manager invests simultaneously in a long and short positions of both companies. The profit is generated through the price-spread arbitrage between the current market price and the future fair value price of the target company, i.e. after the deal completion. The fundamental analysis of the company and the regulatory set up within the industry, the regions or the countries in which company is operating is essential. Depending on the sufficiency of the personal information and the risk appetite the manager will invest in not publicly announced or only publicly announced transactions. One characteristic of the Risk Arbitrage investor is his affinity to the risk management rather than to portfolio management. Any corporate event, bankruptcy, restructuring, merger, acquisition or spin-off is a trade off opportunity.102 Risk Arbitrage strategy provides net average annual return of 14.59% combined with an annual standard deviation of 0.87%.103

Copyright © 2010. Diplomica Verlag. All rights reserved.

An example of basic strategy consists of a bet on an acquisition announcement where company A will acquire company B. The manager simultaneously buys shares of company B and sells those of A. During the acquisition process several bid offers will be announced and influence bidspread premiums, which as the deal is finalized over time will melt to zero. Being long B share and short A means that the fund’s cash outlay for B shares is smaller than the proceeds of A. The arbitrageur calculates a ratio of A for B stock assuming the spread will converge. The changes in the stock ratio leave a residual delta risk in the short position. Risk Arbitrage benefits on capturing the spread between the current and the future market price, i.e. by the time when the merger or the acquisition is completed. The leverage should be low to medium especially in bearish markets leverage will negatively affect the fund’s liquidity. Diversified portfolio consists of several different merger and acquisition bets in order to diversify the exposure towards the specific industry or sector. As the merger or acquisition risk itself is uncorrelated to the market risk an 101 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 17 102 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 34 103 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

36

excessive drawdown indicates poor manager’s skill unless the macroeconomic scenario was a crisis scenario in which correlation towards the markets was substantial.104 The credit risk, depending on the entity and the event type, can be regarded as moderate risk. It is reflected in the companies creditworthy. If the company is insolvent and the acquisition does not take place the fund will hold much lower investment grade than originally anticipated. Sector liquidity is the performance driver in Risk Arbitrage strategies. The liquidity depends on an overall mergers and acquisitions volume, which tend to be very cyclical with a sharp boom and consolidation phases. The merger and acquisition industry is to a great extent influenced by macroeconomic conditions, i.e. the companies´ strong organic growth or a sharp economy decline where weak companies face bankruptcy or restructuring. The legal and regulatory risk is high. Positions are established on an expectation that particular deal will or will not be concluded. The fundamental company analysis, research about the merger or acquisition and the deal structure are central part of the strategy. The manager should have a sound legal advisory support or the background and the ability to filter all deal relevant information, as “right” information interpretation is extremely important for the position establishment and the portfolio rehedging.105 The arbitrageur can also establish positions upon an insider information, rumour or speculation. Trading upon insider information will be legally prosecuted. Trading upon rumour and speculation immensely increase the investment risk. Such position establishment is rather gambling than the strategic investment and by far not what the strategy represents - the “risk management”.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Risk Arbitrage manager should possess the experience and the skill in all financial engineering and risk management disciplines. Essential analytical abilities include the company, the industry and the sector analysis as well as the ability to draw conclusions, estimate the likelihood of actions or legal issues, which will affect the deal approval. Deep insight into the merger & acquisitions process of each merger & acquisitions phase is essential in order to detect potential deal breaker.106 Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for funds style specific risk level scoring according to the table 17. 104 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 28-30 105 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 28-30 106 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 1

37

The table 14 shows major risks in the Risk Arbitrage strategy. Major risks in Risk Arbitrage Strategy The underlying risk Event risk or deal risk: the risk of a deal taking or not taking place at the announced or at the changed terms, the duration of the restructuring process and a cash flow pay off. The style risk Diversification: the exposure towards the specific industry or sector (the portfolio diversification). Duration: the time band till the deal is legally finalized (unforeseen changes or deal breaker). Leverage: the leverage is risky in bearish markets and can negatively affect the fund’s liquidity. Sector liquidity: the strategy execution strongly depends on the market cycles – boom (organic growth of companies) and consolidation (weak companies are facing restructuring and bankruptcy). The skill risk Essential Skill: the manager’s skill and experience are the most important factors. The information is widely and fast available and once existing network advantages, which were the alpha source are diminishing. Thus a superior analytical, managerial and risk management skills are required to generate the alpha. The manager’s who are establishing positions on an insider information, rumour or speculation in the market are a red flag. The market, credit, legal risk Exposure: the residual delta left as a result of the ratio calculation of A to B stock which can be challenging in the bearish market as the strategy strongly correlates towards the equity market. Liquidity: depends on the supply and demand within the industry, the sector and the county. Equities shorting in small and less liquid markets will increase the risk of inflated prices. Credit: in the case of bankruptcy or the M&A event not taking place the fund might be forced to hold very low investment grade securities as a fast exit might not be possible. Legal: very high legal and regulatory risks and the potential legal and regulatory changes within the M&A process - existing & potential legal and regulatory constraints. Crisis scenario Drying liquidity in the industry, the sector, the region and the country. T A B L E 14 : M A J O R

RISKS IN

RISK ARBITRAGE

STRATEGY

Copyright © 2010. Diplomica Verlag. All rights reserved.

4.1.2 Distressed Securities The financial distress, mostly bankruptcy or significant company reorganisation is an attractive trade off. Due to the nature of distressed assets it is mostly buyers’ market and the securities often trade at large discounts. The majority of investors are not willing to take the risk of distressed companies or they are by the law restricted to hold securities below the investment grade and the market is barely covered by the analysts.107

107 Cp. Cottier, Philipp [2000]: Hedge Funds and Managed Futures Performance, Risks, Strategies and Use in Investment Portfolios, p. 134

38

The assets are “mispriced” and do not reflect the companies´ fair value, in particular its future fair value as the positive expectations on the future operating cash flows and the equity value are misconceived.108 The investment in distressed assets is affiliated with a long-term investment philosophy and an exposure towards a scarcely liquid market. The managers are frequently actively involved in the company’s refinancing and restructuring.109 The essential manager’s skills set consists of the fundamental company and macroeconomic analysis, the industry or the sector insight, the people and the company management as well as the refinancing and restructuring skill. The strategy shows high similarity to the private equity investing.110 The distressed Securities strategy provides net average annual return of 10.34% combined with an annual standard deviation of 0.77%.111 As debt and equity positions of the distressed company are established the fund will hold a long-term credit risk. The specific events and important negotiations, which have an impact on the company’s value during the restructuring process, are the additional source of alpha as the short-term trading positions were established upon the expected event or the negotiations outcome. The equity and the interest rate risk are partially hedged by shorting other stocks in the same industry or respectively treasury bonds.

Copyright © 2010. Diplomica Verlag. All rights reserved.

If the company’s market price is lower than its fundamental value the manger will set up and hold positions throughout the restructuring process as he believes that the security will reach its fair value after the restructuring is completed. An alternative alpha source is the intracapitalization or the capital structure arbitrage as the company’s different financial instruments are mispriced relative to each other. The arbitrage is a result of holding the undervalued and short selling the overvalued security. The credit risk will materialize in the long debt position of a low investment grade company, as the fund is long highly default rated risk. The widening credit spreads will squeeze the liquidity. The event risk can be hedged with long and short equity positions. However, it is often an accepted risk, thus left unhedged. The market risk results in rising interest rates, which negatively affects bond’s value. The leverage is zero or very low as the strategy is directional and the risk quite concentrated.112 The Distressed Securities strategy involves two types of personalities, the active and the passive fund managers. An active manager must demonstrate managerial skill and take active restructuring decisions. Additionally the people and the process management skills are essential,

108 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 37-38 109 Cp. Agarwal, Vikas / Naik, Narayan Y. [2000]: On taking the “Alternative” Route: Risks, Rewards and Performance Persistence of Hedge Funds, Journal of Alternative Investments, Vol. 2, No. 4, p. 11 110 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 37-38 111 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11 112 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 37-39

39

which involves a more complex set of skills than buying, holding and shorting securities. A proven track record in the people and the change management adds value. Sharp analytical abilities are essential, i.e. the manager is able to analyse the company, the industry and the sector as well as the bankruptcy law. Regardless being an active or a passive manager, the ability to precisely evaluate securities, debt and collateral as well as the approximate duration the capital will be tied up and the assessment of all probable extraordinary events, which will affect the strategy, is essential.113 The table 15 shows major risks in Distressed Securities strategy.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Major risks in Distressed Securities Strategy The underlying risk Distressed debt security and the restructuring process, the interest rate risk, FX risk. The style risk Duration: long-term investment - long lock up & redemption periods, the fund’s liquidity. NAV volatility: due to the assets nonliquidity NAV tends to be more volatile as within the relative value and the market neutral strategies. The skill risk Leverage: should be non to very low - otherwise highly risky due to directional bets and the lower sector liquidity. Essential Skill: the manager’s skill and experience are the most important factors in an event driven strategy. Since there is no substitute for being actively engaged in the company management the skill should range from the company evaluation till the active restructuring management of the companies as well as the change and the people management. The market, credit, legal risk Exposure: a short term trading in an anticipation of the specific event and important negotiations. Liquidity: the liquidity risk degree depends on the supply and the demand within the industry, the sector and the county. The sellers will experience losses and as they are forced to hold the assets. The assets will be evaluated market-to-market affecting NAV, the fund’s liquidity and the assets and the liabilities management. Credit: the corporate risk entails any worsening of the companies’ financial situation and competitiveness during the restructuring phase, long term credit risk of a low investment grade company, the widening of the credit spreads. Legal: present at all times and regardless how good the legal due diligence was during the restructuring and holding period distressed company can face an unexpected legal ruling. Settlement: complex settlement, which can take a long time - third party risk. Crisis Scenario Any crisis drying the market liquidity, in particular in the emerging markets. T A B L E 15 : M A J O R

RISKS IN

DISTRESSED SECURITIES

STRATEGY

The fund’s redemption periods should reflect the long-term capital unavailability. The management has to ensure that the investor’s “weak hand” does not endanger the fund’s performance. Therefore a broad and 113 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 37-39

40

stable base of the already invested and the potential investors is important. The illiquid assets and the skewed buyers market can temporary suffer a liquidity squeeze especially when the risk attitude towards the specific company or the fund itself changes and a market exit is not possible. The NAV volatility is higher than with the fund’s operating in liquid markets with low prices volatility.114 Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for funds style specific risk level scoring according to the table 17. 4.2

Strategy Risk Level Aggregation

The major strategy risks analysis is verified through a consistency check. In general the analysis should start with an assessment of the strategy strengths and weaknesses as well as the internal and the external factors, which influence those positively or negatively. The evaluation of practical risks, which might emerge in or outside the fund includes the management, the concentration risk, the policy accuracy, the leverage, the skill, the hedging and the macroeconomic risk that is reflected in a crisis scenario. The combination of those factors should illustrate how the fund has performed in the past and will potentially in the future if the key variables do not change dramatically over the intended investment period.

Copyright © 2010. Diplomica Verlag. All rights reserved.

In general it can be stated that every fund is different and will have different risk attributes, which makes it difficult to think in the categories and trivialise. The understanding of the business model, the alpha source, the strategy and the different types of risk the fund is taking is essential for its risk classification. Those factors are negatively amplified by high leverage and when assets are turning from liquid to nonliquid at times. Thus the framework suggests to firstly analyse the underlying, the style, the skill, the market, the credit, the legal as well as other strategy specific risks. Secondly, before scoring the fund to a specific risk level the consistency check of the examined major strategy risks according to the table 16 has to be done. That means the plausibility check regarding the management, the strategy, the skill, the instruments, the hedging, the portfolio concentration, the limits, the investment policy and the leverage is necessary in order to see the full picture and how the risk components interact with each other.

114 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 37-39

41

In following a general single strategy risk questionnaire and a scoring table reflecting the fund’s risk profile are represented. The table 16 shows plausibility check for the major single strategy risk evaluation before scoring the fund to a specific risk level. The consistency check of major style specific risks Can the management explain the exact strategy and the alpha origin? Can the management explain why the fund is different from the peers – the fund’s differentiation profile towards its peers is clear and plausible? What are the strengths and weaknesses of the strategy? Do the “skill” and the used instruments (futures, options…) match the strategy? Can the geographical market focus constrain the strategy execution? The portfolio concentration (the number of instruments and the exposure bias). The position limit problems (breach of limits, limits not sufficient). The hedging style and the level and how often is the portfolio rehedged? How is the rebalancing of the long-term policy done? The leverage in connection with the market liquidity and the fund’s market exposure. Is the leverage policy existent and followed? T A B L E 16 : C O N S I S T E N C Y

CHECK OF MAJOR STYLE SPECIFIC RISKS

The fund’s risk can be scored according to the table 17. It illustrates the risk level categorization scale for the strategy specific risks. The risk level score

Very Low 1

Low 2

Average 3

High 4

Very high 5

The underlying risk The style risk The skill risk The market, credit, legal risk The risky crisis scenario and its probability

Copyright © 2010. Diplomica Verlag. All rights reserved.

T A B L E 17 : T H E

STRATEGY SPECIFIC RISK-SCORING TABLE

The Risk Arbitrage strategies are extraordinarily skill deep. The Distressed Securities strategy is people-intensive and involves the business management skill. The restructuring of a company involves the cultural change management, the financial turnaround and eventually the product line-up diversification. The excessive risk or return is embedded in the management team, which means, the most attention in the risk assessment process should be concentrated on the management team skill and its interaction. Diversified portfolios and a moderate usage of the leverage are crucial. The combination of diversification and leverage influence the fund’s risk level. Concentrated and highly leveraged is usually toxic especially when the asset liquidity dries. Even the best skilled risk managers cannot reliably predict the future. Thus probabilistic modelling of an extraordinary event with the set of reasonable parameters is essential. Also the macroeconomic context plays a significant role. The macroeconomic

42

Copyright © 2010. Diplomica Verlag. All rights reserved.

downturns, i.e. bursting bubbles, and the boom periods, i.e. fast growing industry and extended credit lending, offer attractive investment opportunities but also bear risks. When assessing the fund’s risk level a significant attention should be paid to the current and the expected future industry shape and the overall macroeconomic conditions.

43

5. Opportunistic Strategy Risk 5.1 Opportunistic Strategy Risk “I don’t play the game by a particular set of rules; I look for changes in the rules of the game” George Soros115 The Opportunistic strategies combine the elements of the relative value and non relative value strategies and can be seen as the hybrid of the two. The market exposure and the volatility are symptomatic. The higher the degree of investing in a market direction the higher is the potential of the excessive returns but also the NAV volatility. As a result of a higher volatility the risk-adjusted returns are lower than with Relative Value and Event Driven strategies.116 The market directional bets are typical and beta factors are significant. The large scale bets expose the portfolio towards an excessive market risk as the greater portion of the portfolio is left unhedged. The leverage ranges up to ten times the fund’s equity. An excessive leverage would needlessly increase the investment risk, which in comparison to the return would not be justified, as the loss amplitude would be much greater than the return amplitude. The return volatility is typical and should not be regarded as an unexpected risk. Nevertheless the investor should examine whether the return was generated by luck or skill. Market timing is critical thus the management has to possess an eminent trading experience.

Copyright © 2010. Diplomica Verlag. All rights reserved.

The Opportunistic strategies offer net average annual return between 2.25% and 16.11% combined with high annual standard deviation between 1.08% and 2.10%, which demonstrates the funds expected risk/return profile.117 If the fund is far out of the range the investor should pay attention to it as the fund might bear an unexpected risk. The managers whose investment mandate is not constrained can take a bet on anything. Subsequently the managers´ skill has the higher rate of contribution to the return than e.g. with the Relative Value strategy.118

115 Cit. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 40 116 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 40-41 117 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11 118 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 52

44

5.1.1 Global Macro Global Macro strategies come up from the macro economical analysis and the attempt to figure out the substantial market inefficiency or an arising market trend, e.g. substantial shifts in the interest rates, the currencies and the equities.119 Global Macro funds are extremely flexible in decision making regarding the investment strategy, as an efficient and fast investment strategy implementation into the practice is essential for the successful trade off.120 Global Macro funds operate in liquid and as efficient regarded markets such as the equities, the foreign exchange, the fixed income or the futures markets. Large amounts are invested and highly leveraged directional bets placed thereby not disclosing positions in order to preclude copycats.121 In the extreme market conditions prices fluctuate more than two standard deviations from the mean thus are favourable environment for the bets against the inefficiency. Such market conditions are great source of alpha and occasionally push the extreme prices back to the mean.122 According to Richard Backstabber each year every financial market experiences one or more daily price moves of at least four standard deviations. And in any year at least one market experiences daily moves greater than ten standard deviations.123

Copyright © 2010. Diplomica Verlag. All rights reserved.

Global Macro strategy provides net average annual return of 11.10% combined with an annual standard deviation of 1.10%.124 The fund is moving from opportunity to opportunity attaining alpha, which source are the temporary behavioural biases or the asymmetric information distribution. The strategy is opposite to the Relative Value and Market Neutral strategies. While the arbitrageurs profit on the price discrepancies the Opportunistic strategy is looking for the rare events, which have pushed the particular market far from the equilibrium or the asset price from its intrinsic fair value.125 An opportunistic fund, which has a mandate to invest in anything general partners believe to yield profit will have no investment restrictions and can be a threat for the capital at stake. George Soros's funds have in the past been very successful in their returns based upon market timing but have lost substantial amounts when getting the timing wrong. 119 Cp. Cottier, Philipp [2000]: Hedge Funds and Managed Futures Performance, Risks, Strategies and Use in Investment Portfolios, p. 139 120 Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 148 121 Cp. Blum, Catherine [2000]: Hedge Funds eröffnen neue Anlagehorizonte, p. 248 122 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, pp. 42-44 123 Cp. Bookstaber, Richard [1996]: “Global Risk Management: Are We Missing the Point?” (presentation given at the Institute for Quantitative Research in Finance, October 1996 124 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11 125 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, pp. 80-81

45

The table 18 shows major risks in Global Macro strategy. Major risks in Global Macro Strategy The underlying risk Any underlying offering a trade off due to the substantial market inefficiency. The style risk Model risk: an effective risk management is most important, the model assumptions and the calibration. The unexpected rare event endangering the strategy execution or the risk management. Market timing: wrong market timing results in substantial losses. Position size: the inadequate limitation of the bet position size (should be limited to 1% or 2% of the fund’s NAV). Leverage: due to the market directional bets and the exposure towards the market volatility an even unleveraged fund can suffer substantial loss, the leverage exaggerates losses and an unexpected rare event can wipe out the fund. The skill risk Essential Skill: the trading experience and a deep insight into the theoretical models and the academic research is a must have as well as the ability to recognise changes and to question own anticipation and views. Hubris, the manager’s vast conviction or arrogance is a red flag for every investor – having the mandate to bet on anything in the volatile markets the ignorance to adapt increases the potential of the loss dramatically. The market, credit, legal risk Exposure: the undiversified and directional risk exposes the fund to all kinds of market risks depending on the bet or the instrument. Volatility: is a negative attribute if the investor does not want to bear the risk of the volatility in general. In particular the investor can distinguish between the upside and the downside volatility. If the fund shows positive skewness and the manager’s personality doesn’t show the appearance of hubris the fund is not a red flag. Crisis scenario Markets without any substantial standard deviations and inefficiencies over a longer period of time. T A B L E 18 : M A J O R

RISKS IN

GLOBAL MACRO

STRATEGY

Copyright © 2010. Diplomica Verlag. All rights reserved.

Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for funds style specific risk level scoring according to the table 22. As an opportunistic strategy means betting against liquid but unbalanced markets with few and large scale opportunities returns will be almost unpredictable, unsteady and highly volatile. Actually nothing is predictable when the management has the mandate to invest in anything offering trade off across multiple sectors and a broad range of trading instruments in a less predictable and by market participants’ biased views driven markets. The fund is betting against market’s “wrong” perception of an assets’ fair value. The essential tools for the strategy execution are the strong personality, the experience, the sophisticated stop-loss techniques and models that can accurately capture the market timing. The manager’s skill and track

46

record as well as the return skewness and the volatility are parameters, which ought to be cautiously evaluated.126 The trading experience in diverse assets is inevitable as well as the ability of the securities picking and their intrinsic value estimation. Managed Futures managers betting in futures markets require a very good global and macroeconomic scope. The main risk is the market risk as an unhedged, directional exposure towards different markets is the source of the alpha and of the potential loss. 5.1.2 Emerging Markets The alternative investment funds investing in the emerging markets predominantly take positions in equity and debt markets. The characteristics of the emerging markets are the inefficiency, the nonliquidity and the volatility. The typical unfavourable market conditions include lack of the custody services, the settlement and clearing procedures, the high exchange and interest rate risks, the low government credit rating, the restricted access for foreigners, sometimes unreliable financial statements published by the companies and the high political and regulatory risks.

Copyright © 2010. Diplomica Verlag. All rights reserved.

The debt instruments show the characteristics, which are more similar to the equity rather than to fixed income securities. As financial markets lack suitable and innovative operational tools, which matured markets provide the available set of the tools to hedge the risk in general and preferably at a low cost is limited. The fund is exposed towards the market risk, as short selling or use of derivatives is limited.127 Indicative for the managers operating in emerging markets is their special know-how about the single market or the personal connections to the local organisations and institutions.128 “A risk to the pessimist is an opportunity to the optimist. Investing in emerging markets therefore is full of risks or opportunities, depending on your viewpoint. The risks include the difficulty of getting information, poor accounting and lack of proper legal systems, the unsophisticated investors, political and economic turmoil, and companies with less experienced managers. The opportunities are due to yet-to-be-exploited inefficiencies or undetected, undervalued and under-researched securities”.129 In the globalizing world well managed emerging markets strategies offer opportunities. As emerging markets undergo rapid economic development, 126 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 80 127 Cp. Cottier, Philipp [2000]: Hedge Funds and Managed Futures Performance, Risks, Strategies and Use in Investment Portfolios, p. 137 128 Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 150 129 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 47

47

are improving their legal and political framework and liberalise financial system they are offering an interesting opportunity for the mid and longterm investor. The strategy provides net average annual return of 2.25% combined with an annual standard deviation of 2.10%.130 The strategy example would be holding of the emerging market security with or without currency bet. An undervalued financial instrument is held long and the residual risk such as the currency or the interest rate risk is hedged. The table 19 shows major risks within Emerging Markets strategy. Major risks in Emerging Markets Strategy The underlying risk Equity and debt markets (interest rate, FX risk and so on), unreliable financial statements. The style risk Political and regulatory risk: very high as the countries are politically instable and low creditworthy rated. Infrastructure: the emerging markets often lack good custody services, impose restricted access for foreigners to information or other services, inadequate IT infrastructure. NAV volatility: due to assets nonliquidity NAV tends to be more volatile as with Relative Value and Market Neutral strategies. The skill risk Leverage: due to the lower liquidity in the overall markets and single instruments the leverage should be cautiously used, thus low leverage is typical. Essential Skill: crucial is the manager’s connection and understanding of the countries´ and the markets´ particularities that are the source of the trade is off and the portfolio risk management. The market, credit, legal risk Exposure: long exposure to the market risk, as the short selling and derivatives hedging usually is limited. Liquidity: nonliquid markets bear the risk of the higher NAV volatility and low chance to exit the positions at the desired price. When under pressure the emerging markets mostly do not offer an acceptable exit and the fund will end up holding the assets, which sharply lose in value. When additionally due to the investors´ “weak hands” the fund loses assets an additional pressure on the fund’s NAV and the liquidity arise. Credit: holding the low investment grade debt and the low countries credit worthy. Crisis scenario: Any political or economical distress could heavily affect the strategy as politically instable and from the jurisdictional point of view insufficiently regulated countries are highly risky particularly for the foreign investors.

Copyright © 2010. Diplomica Verlag. All rights reserved.

T A B L E 19 : M A J O R

RISKS IN

EMERGING MARKETS

STRATEGY

Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for funds style specific risk level scoring according to table 22.

130 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

48

The manager also might bet on an undervalued or overvalued currency, though it can be very risky due to the country’s low credit worthy. Long exposure in the equity markets entails the market risk, while the credit risk is evident in the large exposure towards the countries credit rating. The market’s nonliquidity is the core risk and can jeopardize the fund’s liquidity, while on the other hand due to an investment in the emerging market the fund provides liquidity to the market. The political turmoil or jurisdictional changes can negatively affect strategy execution. Hedging and shorting is difficult as the short selling or use of the derivatives is limited. In the emerging markets the single stocks correlation is much higher than in the developed markets. While the correlation among the single emerging markets is lower than within the developed markets. Thus the investments in different emerging markets diversify risk. The leverage can be up to ten times the fund’s equity. 5.1.3 Long/Short Equity

Copyright © 2010. Diplomica Verlag. All rights reserved.

The Long/Short Equity strategy is a combination of buying the undervalued and selling the overvalued equities. As a result the fund is long undervalued and short overvalued equities. If the fund operates within the same sector and the long and short positions are of the same extent it is a pair trade execution. The strategy strongly correlates with the equity markets. A moderate or even negative correlation towards bond markets, as long as the macroeconomic conditions do not change, is typical. The portfolio shows long bias, which means that the manager is holding major positions in the undervalued equities.131 The key to the out-performance is the stock picking in the bull as well as in the bear markets. The short positions are an instrument to hedge the market risk. By using the debt capital disproportionate return or loss can be gained.132 The investment focus is regional, sector specific or style specific. The monitoring of the stock specific risk as well as the stock and the general market liquidity control is critical.133 The strategy provides net average annual return of 16.11% combined with an annual standard deviation of 1.08%.134 The strategy example would be holding long undervalued and selling short overvalued equity as a result of the companies and the macroeconomic factors analysis. For example if the company announces the growth rate projection, which is attributed to the specific industry and by far exceeds buyers market the growth is an indicator for falling operational cash flow, which in consequence leads to a lower earnings than originally estimated and as a result the stock value should decline. When the stock price is under pressure the manager expects his short positions to lose value much faster than the long positions. The constant alpha is expected from the short positions. The 131 Cp. Schneeweis T, Gregoriev G [2002]: The Benefits of Managed Futures, p. 1 132 Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 131 133 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 49 134 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 11

49

market risk is hedged by selling short the equity or more accurately by use of the derivatives.135 The table 20 shows major risks within the Long/Short Equity strategy. Major risks in Long/Short Equity Strategy The underlying risk Any equity market. The style risk Risk Management: inadequate risk control; sophisticated risk controlling and parameter modelling is essential (stop-loss, concentration, sector, counterparty and market risk limitations, the funds and the position size limitation). Correlation: strongly correlated to the equity markets. Directional bias: undiversified and directional thus an effective risk management is important. Buying or selling of options and the unexpected rare events can lead to great losses. Short squeeze: the origin of the massive upward volatility in the specific stocks hence the price shifts the market to mainly a seller’s market and dries the stocks liquidity. Position size: inadequate limitation of the position size (should be limited to 1% or 2% of the fund’s NAV). Leverage: due to the market directional bets and the exposure towards the market volatility an even unleveraged fund can suffer substantial loss, the leverage exaggerates losses and one unexpected rare event can wipe out the fund. The skill risk Essential Skill: the trading experience and an insight into the security analysis, the understanding of the sector or the industry and the stock picking and the risk management ability. The market, credit, legal risk Exposure: fairly unhedged exposure to diverse sectors or industries. Volatility: is a negative attribute if the investor does not want to bear the risk of the volatility in general. In particular the investor can distinguish between the upside and the downside volatility. If the fund shows positive skewness and the manager’s personality doesn’t show the appearance of hubris the fund is not a red flag. Crisis scenario: The burst of an equity bubble, highly volatile markets where the fundamental security analysis is overridden.

Copyright © 2010. Diplomica Verlag. All rights reserved.

T A B L E 20 : M A J O R

RISKS IN

L O N G /S H O R T E Q U I T Y

STRATEGY

The fund manager establishes concentrated and fairly unhedged positions, which ends in an exposure towards several sectors or industries, thus entails the market risk. The leverage is up to ten times the fund’s equity. The liquidity risk is one of the main risks. Liquid stock markets with less inefficiencies and very low volatility are pre-condition for regular selling and buying of equities. At times excessive positions entering and exiting is necessary and the fund’s size should not constrain its flexibility. A very good operational business set up is essential. The market, the counterparty and the liquidity risk control as well as the daily positions monitoring of VaR, P&L, the asset liquidity, the counterparty and the concentration risks is essential for an appropriate strategy execution. The Long/Short Equity strategies originate from the balance sheet’s key 135 Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 133

50

financial ratios analysis and their interpretation. The company’s strategy understanding as well as an insight into the company’s affairs, the general macroeconomic context, the industry’s and the company’s proposition value is important. The stock picking ability and the intrinsic value estimation is an essential skill. The manager has to be strongly analytical and shouldn’t lack good trading experience. Major risks are categorized in the underlying risk, the style risk, the skill risk, the market & credit & legal risk and the potential crisis scenario. These are used for funds style specific risk level scoring according to table 22. As the cost to set up the business is very low and a lot of long-only managers can switch the industry form the traditional to the alternative without a significant entry barriers, which is good for the manager but not necessarily for the investor. In order to select the performing funds with the reasonable risk management and the risk-reward profile due diligence is inevitable.136 5.2 Strategy Risk Level Aggregation

Copyright © 2010. Diplomica Verlag. All rights reserved.

The major strategy risks analysis is verified through a consistency check. In general the analysis should start with an assessment of the strategy strengths and weaknesses as well as the internal and the external factors, which influence those positively or negatively. The evaluation of the practical risks, which might emerge in or outside the fund includes the management, the concentration risk, the policy accuracy, the leverage, the skill, the hedging and the macroeconomic risk, which is reflected in a crisis scenario. The combination of those factors should illustrate how the fund has performed in the past and will potentially in the future if the key variables do not change dramatically over the intended investment period. In general it can be stated that every fund is different and will have different risk attributes, which makes it difficult to think in the categories and trivialise. The understanding of the business model, the alpha source, the strategy and the different types of risk the fund is taking is essential for its risk classification. Those factors are negatively amplified by a high leverage and when assets are turning from liquid to nonliquid at times. Thus the framework suggests to firstly analyse the underlying, the style, the skill, the market, the credit, the legal as well as other strategy specific risks. Secondly, before scoring the fund to a specific risk level the consistency check of the examined major strategy risks according to the table 21 has to be done. That means the plausibility check regarding the management, the strategy, the skill, the instruments, the hedging, the portfolio concentration, the limits, the investment policy and the leverage is 136 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 36

51

necessary in order to see the full picture and how the risk components interact with each other. In following the general single strategy risk questionnaire and the scoring table reflecting the fund’s risk profile are represented. The table 21 shows plausibility check for major single strategy risk evaluation before scoring the fund to the specific risk level. The consistency check of the major style specific risks Can the management explain the exact strategy and the alpha origin? Can the management explain why the fund is different from the peers – funds differentiation profile towards its peers is clear and plausible? What are the strengths and weaknesses of the strategy? Does the “skill” and the used instruments (futures, options…) match the strategy? Can the geographical market focus constrain strategy execution? The portfolio concentration (number of instruments and exposure bias). The position limit problems (breach of limits, limits not sufficient). The hedging style and the level and how often is the portfolio rehedged? How is the rebalancing of the long-term policy done? The leverage in connection to the market liquidity and the funds market exposure. Is the leverage policy existent and followed? T A B L E 21 : C O N S I S T E N C Y

CHECK OF MAJOR STYLE SPECIFIC RISKS

The fund’s risk can be scored according to the table 22. It illustrates the risk level categorization scale for the strategy specific risks. The risk level score

Very Low 1

Low 2

Average 3

High 4

Very high 5

The underlying risk The style risk The skill risk The market, credit, legal risk The risky crisis scenario and its probability

Copyright © 2010. Diplomica Verlag. All rights reserved.

T A B L E 22 : T H E

STRATEGY SPECIFIC RISK-SCORING TABLE

According to Richard Bookstaber, every financial market experiences one or more daily price movements of at least four standard deviations each year. Usually in any year at least one market experiences daily move greater than ten standard deviations. Looking at the market crash cycles ranging from 1929, 1974, 1987, 1994, 1998 and 2001 to the current 2008 credit crisis, plenty of opportunities emerged for skilled managers in an inefficient and far from “equilibrium” markets. Between each bubble less than 63 years passed and the cycle even shorted as the market matured, more participants entered the market and since 1980s the derivative

52

products were introduced. The market participants act irrationally and create bubbles almost every decade.137 The Opportunistic strategies are characterized by the unrestricted investment mandates and fast moving from one trade off opportunity to the next thus the market timing plays a significant role.

Copyright © 2010. Diplomica Verlag. All rights reserved.

The risk level assessment should focus on the fund’s hedging and rehedging strategy and frequency, the product risk, which means is the fund investing in liquid assets and is the product the traditional or complex structured product. Also the existence of the leverage policy and the fact that it is obeyed as well as the management team attitude and the ability to adapt the models to the changing environment are the most critical risk factors within the strategy.

137 Cp. Bookstaber, Richard [1996]: “Global Risk Management: Are We Missing the Point?” (presentation given at the Institute for Quantitative Research in Finance, October 1996

53

6. Internal and External Risk Factors 6.1 Internal Risks “A safe investment is an investment whose dangers are not at that moment apparent” Lord Bauer138 6.1.1 Hubris Hubris relates to the manager’s personal nature, i.e. his personality. It is not necessarily connected to his skill but affects his perception of the environment, i.e. the markets he is acting in. LTCM is the best example of the reluctance to embrace the changes as well as the expert’s arrogance in terms of the self-assurance.139 The experience has shown that the unregulated market can cause real problems as you trust the management to operate within a certain framework, which due to the "market opportunity" suddenly changes, e.g. the fund’s management states that it will not leverage more than two times the equity but it ends up at five times the equity because it has believed it was the right time to invest heavily. Hubris is a part of the manager’s personality, which can be hardly detected by screening the prospectus, curriculum vitae or internet publications. The face-to-face meetings at the manager’s office and the meaningful questions will disclose manager’s thinking pattern and his perception of the world and the markets he is operating in as well as his capabilities. While some demonstrate “down to earth” attitude and have a realistic views on the world and the markets some show the characteristics of “superheroes”, i.e. tend to rely on the own perception of being impeccable. Less people are blessed with the ability to detect hubris as it is a combination of the industry insight and the psychology knowledge and the long lasting experience of working with different kind of personalities and characters. It is an expert judgement combined with the ability to anticipate the potential future changes of the personality.

Copyright © 2010. Diplomica Verlag. All rights reserved.

6.1.2 The attitude, the structure and the business cycle risk The business is like chess: to be successful you must anticipate several moves in advance in order to have any chance. The alternative investment funds are exposed to the business risk, as they are business. It is the nature of the business that it occasionally fails. To select those who are great business and not a potential failure is the “art” of the investing.140 138 Cit. Ineichen, Alexander M. [2005]: The critique of pure alpha, UBS Warburg, p. 53 139 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 66 140 Cp. AIS Report [March 2005]: The critique of pure alpha , UBS Limited, pp. 73-74

54

It is essential to look at the business plan context, the opportunity the fund has to offer and even more at who will set up and execute the business. If the people involved have no entrepreneurial spirit, the skill required to explore the opportunity and do not fit as a team the likelihood of the business failure is huge. If you have chosen a start up fund and no one of the management team possess the entrepreneurial spirit you are better advised not to invest, as such people do not make it in the alternative investment world.141 The core of the entrepreneurial capitalism is built on three forces; the innovation, the ownership and the adaption, which are the characteristics of the successful money management organizations. In this context the innovation means that the management is able to detect for the most market participants unexpected consequence before it occurs. The superior insight is closely connected to the superior return. The ownership as an organizational structure is an incentive for the management team to preserve the invested capital and to provide superior returns. The carefully structured financial incentive encourages the managers to behave as owners instead of like a fee-driven company worker. The adaption reflects the management’s ability to select and establish the attractive riskadjusted trade off positions from a large universe of the potential opportunities. The ability to eliminate weak positions and to establish new potential return providers is a core skill.142 The underlying asset classes including their life cycle as the markets and the products are changing have an influence on the fund’s future performance. A fund can show fantastic historical risk-return profile but if the underlying assets are undergoing transformations, i.e. due to the regulatory changes or the product innovation it will significantly affect the fund’s future performance. If the management is not able to foresee such changes and adapt those in the strategy the performance might be significantly lower in the future.143 The table 23 represents the checklist for the attitude, the structure and the business risk.

Copyright © 2010. Diplomica Verlag. All rights reserved.

Attitude, structure and business risk The context, the opportunity and the entrepreneurial spirit of the management. The management’s ability to innovate and to adapt to the changing environment. The ownership and the organizational structure (the incentives to preserve the capital). The business attitude (shot-term or long-term oriented) and the fee structure. The fund’s investment conditions: the minimum initial and the subsequent investment, the subscription and the redemption frequency, the redemption notice period, the lockup period and any liquidity constraints. T A B L E 23 : A T T I T U D E ,

STRUCTURE AND BUSINESS RISK

141 Cp. Strachman, Daniel A. [2007]: The Fundamentals of Hedge Fund Management, p. 17 142 Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, pp. 256-257 143 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 104

55

Barton Biggs illustrates an interesting example of problems of the money management in cyclical markets with a businessman attitude, i.e. only maximizing the short-term profitability. In 2000, Morgan Stanley Investment Management promoted the underwriting of the technology and the aggressive growth stock funds. Large amounts of public money were collected and quickly lost. In the spring of 2003, the firm shut down its Asian Equity Fund. The fund shrunk from $350 million to less than $10 million. It was the money-losing proposition and the short–term business decision to close the fund seemed right, as at that time Asia didn’t seem to be of any investors’ interest. But smaller Asian markets were then cheap, the economies were surging and Asian equities were exactly the place to be. Neither the public investors nor the management of the profit-driven investment companies could understand how important it was not to mindlessly follow the crowd.144 “You have to recognize that every “out-front” manoeuvre is going to be lonely. But if you feel entirely comfortable, then you’re not far enough ahead to do any good. That warm sense of everything going well is usually the body temperature at the centre of the herd. Only if you’re far enough ahead to be at risk do you have a chance for large rewards.”145 In general the manager has to demonstrate the skill and the investment knowledge as well as the ability to successfully run and manage the corporation and the people around him in different market conditions. His business and people attitude will to a large extent influence the success of his business. 6.1.3 Operational risk

Copyright © 2010. Diplomica Verlag. All rights reserved.

The sufficient risk management, risk controls and operational processes have to match the minimum requirements of the single strategy. The most excellent trade off opportunity poorly executed is more risky than an average one executed at the top professional level. Beside the statistical indicators and the performance the investors are focusing on the review of the third party agreements such as the audit and the administration. The major failures result from the strategy changes, the fraud or the insufficient risk hedging.146 The trend is going towards timely, standardized and comparable information exchange, both the fund wise and their prime brokers. The third party SLA can disclose whether the fund needs a strong internal operational set up in order to execute the strategy or it is rather a lean fund that can concentrate on the plain trading and stock picking while the most operational processes are done outside the fund.147 The duty segregation, which involves the portfolio manager, who concentrates on 144 Cp. Biggs, Barton [2006]: Hedgehogging, pp. 119-120 145 Cit. Biggs, Barton [2006]: Hedgehogging, p. 120 146 Cp. AIS Report: The critique of pure alpha (March 2005), UBS Limited, pp. 73-74 147 Cp. Murphy, Don / Hawthorne, Ed [2008]: in The Capco Institute, Operational due diligence in the hedge fund world, Wealth - Journal Vol. 15, pp. 53-56

56

generating the alpha, and the CFO and COO, who are responsible for the smooth running of a day-to-day business, i.e. the investor and the thirdparty relations, the regulatory, the back- and the middle-office controls and the accounting has to be in place. Furthermore the staff in charge of the assistance and the oversight of the service provider’s work is needed (i.e. chasing up the outstanding confirmations, cash and the position reconciliation and the trade breaks) as well as the proper compliance set up for overseeing the personal trading, trade errors, KYC requirements and AML supervision. The table 24 shows the checklist for the operational risk. The operational risk The Risk Management and Risk Controlling S&L limits, open positions tracking, correlation calculation method between the instruments. How is the liquidity of the underlying positions measured? How are the size and the limit for the single position determined? What systems are in use and is the operational risk management in place? Is the people skill sufficient for the strategy specific risk management and controlling? Who is in charge of the risk management, the internal or the external managers? The IT systems and the contingency plan Is the contingency plan in place? Is the IT systems support and the back up available, inside the office or with a third party? The compliance and a duty segregation Compliance: personal trading restrictions, trade errors oversight, KYC and AML monitoring. Can any current or potential conflict of interests be detected? If yes, specify and describe the matters, legal, civil, administrative and taxation suits or any other ongoing? Does the fund’s operational set up match the strategy and the fund’s size? Duty segregation: the responsibilities and duties segregation chart. Are the key functionalities segregated or is the portfolio manager also in charge of e.g. the finance and the operations? The Third Parties The list of the third parties: (prime broker, custodian, bank, lawyer, accountant, administrator, auditor…) and the services provided including SLAs. Does each third party match the fund’s needs? The reputation of the fund’s service providers? Can the third party provide standardized/comparable information about the fund’s positions? Can the fund oversee the third parties calculations and reconcile potential errors (confirmations, settlement, NAV calculation and accounting)?

Copyright © 2010. Diplomica Verlag. All rights reserved.

T A B L E 24 : T H E

OPERATIONAL RISK OVERVIEW

The robust internal controls and procedures have to be in place over each stage of the trading cycle (the trade authorization, the execution, the confirmation, the settlement, the reconciliation and the accounting, the trades recording, the assets movements). All potential conflicts of interest should be examined, i.e. is a leading independent third-party the administrator overseeing the valuation process and possesses the thirdparty the skill to accurately price the assets and independently evaluate NAV.148 The fund’s size affects its market and operational risk. The 148 Cp. Nahum, Reiko / Aldrich, David [2008]: in The Capco Institute, Hedge fund operational risk: meeting the demand for higher transparency and best practise, Wealth - Journal Vol. 15, pp. 104-105

57

dynamic positions entering and exiting becomes more difficult the bigger fund’s positions are. The market risk is significant simply due to the higher capital proportion on stake or the position concentration influencing the asset price and the liquidity. Operating in unliquid or niche markets can be accompanied by a higher operational risk. 6.1.4 Fund’s size, funding and leverage The study commenced by James R. Hedges, which was published by Capco Institute, shows that the size affects the fund’s performance. Large funds have the advantage of the better research resources and they are attractive to the talents. Furthermore an increased efficiency in brokerage, an easier access and better bargaining power towards the brand-name service providers is the advantage of a large asset base. But this goes hand in hand with the organizational diseconomies, the personnel management skill and the challenges of alpha exploration as well as the ability to identify the new generation of stars and future cash cows. The performance of the large funds is negatively affected by the liquidity costs. They are not nimble due to their internal organisational structure. Large funds are constrained to fast making investment decisions and are forced to broadly diversify as not all the money can be put in the best ideas. The traders face difficulties when executing the strategy as the ability to short and to fast switch between the positions is reduced. The study showed that the small funds performed best while the medium-sized funds performed worst. Stuck in the middle problem is not only the strategy problem, but also the AuM size problem. The fund has to ascertain an optimal size for the chosen strategy.149 Furthermore the fund’s size should be evaluated in comparison to the peers, in relation to the market volume in this particular strategy and to the underlying asset class.

Copyright © 2010. Diplomica Verlag. All rights reserved.

The critical factor for the future performance is the diversification, i.e. is the fund diversified in a way that it lowers the risk or could the positions combination turn into an additional risk driver. The industry shape is another factor influencing the future performance, i.e. the shrinking, the constant or the growing industry will in a different way affect the fund’s performance. The mismatch between the assets and the liabilities can be a warning sign. The invested capital should be stable. If the capital base is not secure the chance of the money withdrawal at the moment when the capital is needed most increases. The long redemption periods and an actively managed capital base improve the ability to stick to the strategy instead of being squeezed out or a victim of the investor’s “weak hand”.150 149 Cp. Hedges, James R. [2008]: in The Capco Institute, Size vs. performance in the hedge fund industry, Wealth - Journal Vol. 15, pp. 14-17 150 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 66

58

The relation of the manager’s personal investments relative to the clients’ capital and the client structure is a good indicator for the fund’s quality and the management team incentives structure. The leverage is a typical tool used by the alternative investment funds to enhance the return. Though being leveraged, e.g. 2:1 in the fixed income strategy is not the same as being leveraged the same ratio in an emerging markets strategy. The leverage of five times the equity in a market neutral strategy can be a moderate return booster and still a low risk profile. While the same leverage in an opportunistic strategy with a moderate market exposure in volatile markets can go both ways, enhance the fund’s return as well as the loss.151 The fund’s strategy, its leverage and the market liquidity are the major return drivers. They should be firstly examined separately and secondly in combination to each other and thirdly towards the investor’s desired risk profile. The table 25 shows the checklist for the fund’s size, the funding and the leverage risk.

Copyright © 2010. Diplomica Verlag. All rights reserved.

The fund’s size, the funding and the leverage risk The funds size Any size constraints in regard to the strategy, which might affect the future performance. Any size beneficiaries or disadvantages, which might affect the future performance? Total net AuM – is it a small, mid-size or a large fund? Its size relation to the most important peers. AuM – by the investment vehicle. AuM – in relation to the market volume of the strategy and the underlying asset class. Is the fund operating in a shrinking, a constant or a growing investment style/strategy? Diversification Is the fund diversified in terms of the investment styles, does the diversification make sense and does the management match the skill requirements of the specific style? The investors profile Who are the investors and their structure in percentage of the total AuM? When did the largest withdrawals in % of the fund’s equity take place and what was the reason for it? The manager’s co-investments? Funding The fund’s investment conditions: the minimum initial and subsequent investment, the subscription and redemption frequency, the redemption notice and the lock-up period, any liquidity constraints. The cash management policy. Does the fund show a critical mismatch in ALM? If yes, what is the reason for this mismatch? Leverage Does the leverage fit the strategy/investment style and the fund’s market exposure, are the markets volatile and are the markets and the underlying assets liquid? Is the leverage policy in place and does the fund sticks to it? T A B L E 25 : F U N D ’ S

SIZE, FUNDING AND LEVERAGE RISK

151 Cp. Rahl, Leslie [2008]: Hedge Fund Risk Transparency – Unravelling the Complex and Controversial Debate, p. 18

59

6.1.5 Interpersonal relationship, transparency and reporting The transparency towards the investor as well as the personal contacts to the key personnel is crucial. The table 26 shows the interpersonal relationship, the transparency and the reporting issues. Interpersonal relationship, transparency and reporting Have the regular meetings at the manager’s office been done? The information about domicile, legal issues, political situation and taxation (political information relevant for the emerging markets strategies). The transparency and reporting continuity. How easy or how difficult can a specific information be obtained? Changes in the strategy, the leverage, the personnel and other significant changes. The style drift should be a trigger for the due diligence and the skill assessment. Changes in the reporting any changes in the manager’s personality should be questioned and observed. The set up of the investor relations and the reporting (the people in charge, frequency, the information quality, the immediate information about the major changes regarding – the trading, the risk management, the strategy, the key personnel left/employed. Can all trades be reported on a daily basis? To which database the performance is reported? If not, why not? Can portfolio data be provided electronically (positions, concentration, exposure, performance attributes, and hedge)? T A B L E 26 : I N T E R P E R S O N A L

RELATIONSHIP, TRANSPARENCY AND REPORTING

The alternative investment funds are efficient, dynamic and attractive return generators because of the missing regulatory burdens. On the other side the control of the operational practices might help protecting the investors from the potential blow-up or the fraud.152 “Because so much lies beyond a portfolio manager’s control, superior investors seek to know as much as can be known, reducing uncertainty to the irreducible minimum stemming from unpredictable market and nonmarket variables.”153

Copyright © 2010. Diplomica Verlag. All rights reserved.

6.2 Internal Risk Level Aggregation The potential and the existing risks within the fund were analysed including the hubris, the attitude, the structure and the business cycle risk, the operational risk, the fund’s size, the funding and the leverage and the interpersonal relationship as well as the transparency and the reporting. The combination of those should illustrate how the fund has performed in the past and will potentially in the future if the key variables do not change dramatically over the intended investment period.

152 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 65 153 Cit. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 254

60

The table 27 shows the scoring matrix of the examined internal risks. Very Low 1 Hubris is not present

Low 2

Average 3

High 4

Opportunity is very good, management’ s ability to adapt and innovate is good, investment conditions match the strategy requirements Good risk management / controls, IT systems and contingency plan, a known third parties, good compliance and duty segregation

Opportunity is sufficient, management’s ability to adapt and innovate is sufficient, investment conditions predominantly match the strategy requirements Sufficient risk management / controls, IT systems and contingency plan, third parties, sufficient compliance and duty segregation

Opportunity low, management’s ability to adapt and innovate insufficient, investment conditions match the strategy requirements

Optimal size, very good diversified and funded, very good investors profile / structure, top leverage policy existent and obeyed

Good size, diversification and funding, good investors profile / structure, good leverage policy existent and obeyed

Size, diversification and funding match the strategy, good investors profile / structure, leverage policy existent and obeyed

Very good interpersonal relationship and transparency / reporting

Good interpersonal relationship and transparency / reporting

Average interpersonal relationship and transparency / reporting

Top opportunity, management’s ability to adapt and innovate is very good, investment conditions perfectly match the strategy requirements

Copyright © 2010. Diplomica Verlag. All rights reserved.

Top risk management / controls, IT systems and contingency plan, top third parties, clear compliance and duty segregation

T A B L E 27 : T H E

Risk management / controls, IT systems and contingency plan should be improved, unknown third parties, compliance and duty segregation is sufficient Size, diversification and funding sufficient for the strategy, average investors profile / structure, leverage policy existent but occasionally obeyed Sufficient interpersonal relationship and transparency / reporting

Very high 5 Hubris is present = a red flag Opportunity unclear, management is unable to adapt and innovate, investment conditions don’t match the strategy requirements = a red flag Insufficient risk management / controls, IT systems and the contingency plan, unknown third parties, unclear compliance and duty segregation = a red flag Low diversification and funding, a poor investors profile / structure, no leverage policy is existent = a red flag

Poor interpersonal relationship and transparency / reporting= a red flag

RISK-SCORING TABLE FOR INTERNAL RISKS

In case of hubris scoring fields left blank are purposely left blank. Either the management team shows hubris in which case it has to be scored with 61

a very high risk, five points, or it does not in which case it has to be scored with a very low risk, one point. 6.3 External Risks In following the external risk factors, which have an impact on the particular strategy and the fund’s risk-reward profile are discussed. The most influential risk factors outside the management’s team control are the industry characteristics and the macroeconomic and the legal environment in which the fund is operating. Especially the future potential changes of those factors should be examined, as they can offer an insight to what extent and shape the industry, the legal and the macro economical context might change and thus influence the fund’s future performance. 6.3.1 Industry shape, structure and evolution

Copyright © 2010. Diplomica Verlag. All rights reserved.

The industry shape and dynamic evolutionary processes will cause structural changes in the industry and thus affect the fund’s performance. The table 28 summarizes the examination of the relevant factors for the industry analysis. The evaluation is based on Porter’s basic concepts of the industry evolution.154 The Industry shape, structure and evolution The industry growth: industry growth rate % will determine the intensity of the industry’s rivalry, i.e. is it increasing on a total scale and the funds are gaining AuM and size. Buyer’s learning: trends and modifying segments suggest shift in the demand and growth for a certain product (e.g. in case of the alternative investments it was the riskadjusted return, the portfolio diversification and the drawdown protection as well as the overall industry growth due to the institutional investors increased demand, the more sophisticated investors, the demographic changes and the difficult market conditions offering low returns. The industry maturity: as the industry is maturing and is implementing standards the uncertainty is reduced and the industry attracts new investors (e.g. pension funds and endowments are heavily invested; on the funds side the traditional managers are entering the alternative investment industry). Product innovations: increase in structured products such as the derivatives and the asset backed mortgage securities triggered the industry growth as it has attracted all kinds of investors. Process innovations: innovations can make processes more or less capital intense, increase economies of scale, change the proportion of the fixed costs and extend the experience curve. Government policy changes: the taxation, the reporting, the limitation of the potential investors, and the limitation of the industry growth/size. Is the industry protected or constrained by certain factors? T A B L E 28 : I N D U S T R Y

SHAPE, STRUCTURE AND EVOLUTION

154 Cp. Porter, Michael E. [1980]: Competitive Strategy, Techniques for Analyzing Industries and Competitors, pp. 163-171

62

Subsequent key relationships of the industry evolution are summarised. The industry concentration and the mobility barriers move together. Exit barriers deter the industry consolidation while the long-run profit potential depends on the future industry structure. No concentration takes place if the mobility barriers are low or falling.155 The alternative investment industry has changed the shape in the past twenty years. After 1987 crash, the most firms scaled back the operations and laid off people and scaled back the compensations of those who remained employed. A large scale of skilled unemployed people decided to become entrepreneurs setting up the own money management partnerships. The lawyers, the accountants and the prime brokers saw an opportunity offering services to the alternative investment funds. This combined with the large assets inflow lead to an explosive industry growth. As a number of the prime brokers, the lawyers, the accountants and the administrators conducted the businesses with start-ups and young entrepreneurs and accepted the associated financial risks they pushed the entry barriers low enough to let the industry explosively grow, which resulted in attracting further investors. For some investors it was an advantage and for the others a disadvantage depending on the fund’s performance thus emphasising the importance of the due diligence within the growing industry.156 6.3.2 Industry rivalry

Copyright © 2010. Diplomica Verlag. All rights reserved.

The industry rivalry affects the fund’s future performance. If the competition within the industry grows faster than the industry itself it will have the profit reducing effect. If the entry barriers are high and the industry shows a slow growth and new funds are not entering the industry it will have the positive effect on the fund’s future performance. In the changing industry the management has to adapt, to change and eventually innovate the existing strategy. If the management has the ability to adapt to evolutionary processes the fund has a good chance of at least maintaining the up to date return strength. The maturing industry has the disadvantage of a high competitiveness thus reduces the profit potential. The IT system improvements can increase the performance of quantitative strategies mainly relying on the systems as these are not research, traders and analysts intense. The technological or the process improvements will positively affect the human professionals’ intense strategies as these can lower the process cost and increase the economies of scale. The industry changes can negatively affect the strategy, e.g. the quantitative edge for the Convertible 155 Cp. Porter, Michael E. [1980]: Competitive Strategy, Techniques for Analyzing Industries and Competitors, pp. 184-187 156 Cp. Strachman, Daniel A. [2007]: The Fundamentals of Hedge Fund Management, pp. 11-12

63

Arbitrage strategy has disappeared due to technology changes. It has made the once existing information advantage disappear.157 The table 29 is an overview of the factors influencing the industry rivalry. The factors changing the industry rivalry The number of funds in general and within the specific style – is the industry growing or declining? AuM in general and within the specific style – are the assets growing or declining? AuM per fund within the specific style- concentration of assets per fund? The investors demand for the specific investment style? Any change in the fund’s cost structure? Changes in the fee and the management provisions, the lock-up period and the hurdle rate - fees and provisions are diminishing, lock-up period shortens and the hurdle rate goes up? The negotiating power of the investors grows. The negotiating power of the service providers grows. Low or high entry barriers for the specific strategy (technological, proprietary knowhow)? Low or high exit barriers for the specific strategy? The peer group structure (1st to 4th quartile funds categorisation). The products standardisation – less complexity can offer less inefficiency. The technological IT advancement – can be positive and negative, it can improve the funds internal cost structure and the efficiency but also lower the entry barriers. The investors’ structure - how is the investors’ structure and their investment power changing? T A B L E 29 : T H E

FACTORS CHANGING INDUSTRY RIVALRY

Copyright © 2010. Diplomica Verlag. All rights reserved.

The Long/Short Equity strategies have very low entry barriers as costs to set up the business and the complexity of the infrastructure in order to execute the strategy is low. They count for the largest category in the alternative investment world remarkably booming during cyclical changes from bear to bull markets.158 In order to assess the fund’s alpha and the management team competitiveness a comparison towards the main peers in the same or similar strategies should be done.159 In general the industry attractiveness can be evaluated with following criteria; the size and growth rate of the industry, the fee rates and the fee structure, the industry and the single strategy competitiveness, AuM inflow and the investors structure (the buyers), the legal and the political changes, the growth and the quality of the service providers (the suppliers), the business cost structure and the technological (IT systems) infrastructure improvements.

157 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 171 158 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 36 159 Cp. Venzin, Markus / Rasner, Carsten / Mahnke, Volker [2005]: The strategy process, p. 75

64

The table 30 represents the fund’s proposition and the industry attractiveness matrix.

The Fund’s Proposition

The Industry Attractiveness High

Medium

Low

High Medium Low

T A B L E 30 : F U N D ’ S

PROPOSITION AND INDUSTRY ATTRACTIVENESS

The fund’s proposition within the industry is influenced by its size, AuM inflow or outflow, the fee structure and the strategy’s strengths and weaknesses. Furthermore the opportunity and the management team, the fund’s image and the cost structure, the financial strength and the return profile are important differentiation factors.160 If the fund’s current proposition is low but the fund will undergo changes, which will positively affect its performance in the near future the fund can be a good investment target even in the mid range attractive industry. While the combination of the low industry attractiveness and the medium fund’s proposition will impose constraints, which can be very difficult and costly to overcome in the short-term investment period for the fund with the medium proposition. 6.3.3 Trends and new strategies

Copyright © 2010. Diplomica Verlag. All rights reserved.

The trend analysis can help to detect potential and not yet explored investment modes. It will provide the information about the industry fragmentation and development. Some of the trends will have the potential to create niche markets and for the opportunistic investors with the substantial risk appetite a good trade off alternative. The trends can also show the corridor of disappearing strategies. The trend assessment is highly connected with uncertainty. It is very difficult but crucial to detect the important and the realistic future market driver trends from the unimportant ones.161 The market trends should be evaluated in combination with the macroeconomic scenarios as those will essentially influence the future performance and can turn the top into the poor performer. As the environment and the financial markets change over time the newer strategies offering an attractive trade off emerge. Since mid 1990s, the alternative investment funds entered the real estate (REITs), the insurance and reinsurance, the energy, the emission trading and the direct financing 160 Cp. Porter, Michael E. [1980]: Competitive Strategy, Techniques for Analyzing Industries and Competitors, p. 365 161 Cp. Venzin, Markus / Rasner, Carsten / Mahnke, Volker [2005]: The strategy process, p. 73

65

of public companies and established diverse niche strategies. The private investment partnerships offer favourable structure to enter new and novel investment ways into the niches where commercial money usually would not flow in or is due to regulation restricted. The newer strategies can be considered riskier due to the range of factors, i.e. the underlying complexity, the market size, the underlying volatility, the direct market exposure and in case of the direct financing holding of the substantial credit risk. The direct financing strategy has overcome the niche status by AuM as meanwhile it counts for $20bn market. As the trading and commission margins in the banking industry came under the pressure the coverage of small companies whose shares do not trade actively have been suspended from the research lists and thus the information on small and micro caps became rare and insufficient. For small and micro cap companies the research is costly and in relation to the riskiness of the opportunity combined with the low financing amount rather expensive. Additionally the low margin profile of such companies was unattractive for the commercial banks, which in the past pushed the business towards the large-scale companies with the low risk profile. As a result they paved the way for the alternative investment funds, which were taking the risk and financed small and micro caps in areas such as the biotech, the healthcare and the energy. When the business sector is very strong and the capital is scarce there is a potential of high returns. According to HFRI Reg D Index the direct financing strategy has averaged 17% annual return.162 Depending on the investor’s risk appetite the industry trends and the niche strategies can be attractive investment targets.

Copyright © 2010. Diplomica Verlag. All rights reserved.

6.3.4 Macroeconomic scenarios Looking at the strategy in the macro context prevents from investing in the strategy, which in upcoming years will experience tough market conditions, a high competitive environment and eventually will suffer capital loss. For example the event driven strategies are based upon corporate events and are strongly dependent on the business cycles. M&As tends to occur with a greater frequency in the prospering economies when business confidence is high and the credit lending easy available. The opposite is the case in the recessionary periods, which are favourable for the distressed securities strategies.163 During the summer of 1998, the liquidity risk at times outweighed the market risk of high-yield bonds, the emerging markets and the mortgage-backed securities. In order to capture the risk of rare events one has to ask the right question in terms of the likelihood of the rare event as well as in terms of the rare event itself. Simulating the worst-case scenario on a highly probable but 162 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, pp. 211-224 163 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 98

66

“wrong” rare event or on a less probable but “right” rare event does not ensure loss protection. Analysing historical time series gives an idea of how something has happened but does not help to foresee the rare event, which is likely but has not yet occurred. The initial questions the risk manager has to ask are; which are the probable rare events likely to occur, and which potential risk factor combinations are highly probable in the specific economic scenario.164 The table 31 shows factors, which significantly influence the strategy and the funds performance either negatively or positively. Factor / Strategy Political changes Economic changes

Relative Value Convertible Arbitrage Fixed Income Arbitrage

Event Driven

Distressed Securities, Risk Arbitrage Distressed Securities, Risk Arbitrage All strategies Distressed Securities, Risk Arbitrage

Market cycles (boom / downturn) Social changes Product & technology innovation

Opportunistic Emerging Markets Long/Short Equity

All strategies Quantitative Market Neutral

Global Macro All strategies

Source: according to Porter, Michael E. [1980]: Competitive Strategy, Techniques for Analyzing Industries and Competitors T A B L E 31 : PEST F A C T O R S A F F E C T I N G T H E S T R A T E G Y

The table 32 shows an example of the positive and the negative scenarios and their probabilities of entry. Macroeconomic scenario / Event The scenarios negatively affecting the strategy

10%

The exogenous shock - either positive or negative

20%

The scenarios positively affecting the strategy

50%

T A B L E 32 : T H E

Copyright © 2010. Diplomica Verlag. All rights reserved.

Probability of entry %

MACRO SCENARIO AND ITS PROBABILITY

When several risk factors appear combined they can cause serious problems. Especially dangerous are the hard to predict events, i.e. the political, the economical or the exogenous shocks.165 The exogenous shocks seem to be arriving in the shorter terms and with the regularity. They are evident in much shorter cycles, e.g. 9/11 in 2001, the tsunami 2004 and the hurricane season in 2005.166

164 Cp. Taleb, Nassim Nicholas [2005]: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, pp. 103-114 165 Cp. Surowiecki, James [2004]: The Wisdom of Crowds, pp. 238-241 166 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 122

67

6.3.5 Investment process and research The investment policy has to cover the strategic (long-term) and the tactical (short-term) aspects of the portfolio management. The small size funds employing one or two manager are nimble and fast in decisionmaking as their structure is lean. The large size funds with a complex matrix structure and several decision-making bodies need the structured investment process. As the groups increase in size consensus thinking dominates the processes. To ensure that the conformity thinking does not dominate the decision processes and enough room for an unconventional thinking is left the teams allowed to make the investment decisions should not exceed the maximum size of three people. The disciplined and rigorous process of setting the asset allocation targets ensures that the short-term investments do not follow the whims of the fashion thus endangering the advantage of the long-term opportunity.167 Apart from the basic organizational and the policy aspects the process of the investment decision-making prior to the investment is extremely important. The fundamental analysis of the opportunity has to match the specific investment style requirements. That means the Relative Value manager will use different investment research tools and approach than the Event Driven strategy manager. While statistical arbitrage strategy is IT system based usually trading automatically the global macro strategy is research intensive. The manager analyses the macro conditions and then looks at the micro context, i.e. the individual positions and their future value in the macroeconomic context. An example is the macroeconomic decision to go short France because the overall economy is poor and then choosing the individual stocks that are expected to be the worst performing. The table 33 shows the investment process and research questionnaire. The investment process and research Is the strategic investment policy (long-term) and the tactical investment policy (shortterm) in place? Does the structural framework for the investment process exist? How is the investment research done - internally or externally and by whom? Does the research extent and the people involved match the strategy requirements? Which (outside) research sources are used? The process from the investment idea until the execution and position establishment. How is the back testing done? Copyright © 2010. Diplomica Verlag. All rights reserved.

T A B L E 33 : I N V E S T M E N T

PROCESS AND RESEARCH

The fundamental research covers the top-down and the bottom-up analysis of diverse markets and is people and skill intensive. The analysis level performed by the manager or the external source prior to the investment is extremely important as it must match the strategy specific requirements in terms of people, systems, analysis and information coverage. 167 Cp. Swensen , David F. [2000]: Pioneering Portfolio Management, pp. 321-336

68

6.4 External Risk Level Aggregation The analysed risks include the industry shape, the structure, the evolution and the rivalry, the trends and new strategies, the macroeconomic scenarios, the investment process and research. The combination of those should illustrate how the fund has performed in the past and will potentially in the future if the key variables do not change dramatically over the intended investment period. Some risk factors must be scored with min. or max. points and some cannot be regarded as an average risk thus those fields are blank. Very Low 1 PEST analysis conclusion: the industry changes will have none negative impacts on the fund’s performance

Copyright © 2010. Diplomica Verlag. All rights reserved.

Low industry rivalry and cost structure, high entry barriers, low exit barriers

Industry Attractiveness & funds proposition is excellent (high/high) High likelihood of several positive macroeconomic scenarios in the near future Investment policy, process and research perfectly match the strategy, backtesting confirms the expected returns T A B L E 34 : T H E

Low 2 PEST analysis conclusion: the industry changes might have slightly negative but manageable impact on the fund’s performance Low industry rivalry and cost structure, medium entry barriers, medium exit barriers Industry Attractiveness & funds proposition is very good (high/medium)

Average 3

High 4 PEST analysis conclusion: the industry changes will have negative impact on the fund’s performance

Very high 5 PEST analysis conclusion: the industry changes will have significant negative impact on the fund’s performance

Medium industry rivalry and cost structure, medium entry barriers, medium exit barriers Industry Attractiveness & funds proposition is good (medium/ medium)

Increasing industry rivalry, high cost structure, low entry barriers, high exit barriers

High industry rivalry, high cost structure, low entry barriers, high exit barriers

Industry Attractiveness & funds proposition is poor (medium/low)

Industry Attractiveness & funds proposition is very poor (low/low) High likelihood of several negative macroeconomi c scenarios in the near future Investment policy, process and research don’t match the strategy, backtesting doesn’t confirm expected returns

Investment policy, process and research match the strategy, backtesting confirms the expected returns

Investment policy, process and research partially match the strategy, backtesting partially confirms expected returns

RISK-SCORING TABLE FOR EXTERNAL RISKS

69

7. Due Diligence framework, conclusive reflexion and closing remarks 7.1 Framework for assessing the fund’s risk profile “I am more concerned about the return of my money than with the return on my money” Will Rogers (1879-1935)168 The subsequent chapter describes the framework for the fund’s risk level assessment. The examination of the major risks within the alternative investment fund starts in chapter two with the management team, the statistical indicators and the fund’s performance evaluation. The chapter three to five evaluate the style specific risks on an example of the most common strategies within Relative Value and Market Neutral, Event Driven and Opportunistic investment universe. The fund’s risk level is aggregated in the scoring table based on criteria; the underlying, the style, the skill, the market & the credit & the legal risk as well as an unfavourable macroeconomic scenario. Chapter six covers the analysis and the scoring of the internal and the external risks. Those include hubris, the attitude, the structure and business cycle risk, the operational risk, the fund’s size, the funding and leverage, the interpersonal relationship, the transparency and reporting, the industry shape, structure and evolution, the industry rivalry, the trends and new strategies, the macroeconomic scenarios and the investment process. The table 35 shows the risks evaluation framework in its single analysis parts. Risk types Management team - Chapter 2.2 Statistical indicators and performance interpretation - Chapter 2.3

Score min. 5 / max. 25 min. 5 / max. 25

Investment style specific risks – Chapters 3.2 / 4.2 / 5.2 Internal risks - Chapter 6.2

min. 5 / max. 25 min. 5 / max. 25

External risks - Chapter 6.4 Copyright © 2010. Diplomica Verlag. All rights reserved.

Sum T A B L E 35 : T H E

min. 5 / max. 25 min. 25 / max. 125

FRAMEW ORK FOR FUND’S RISK PROFILE ASSESSMENT

According to the table 35 the single risk type sum is added together and reflects the fund’s total risk score.

168 Cit. Ineichen, Alexander M. [2004]: European rainmakers, UBS Warburg, p. 19

70

The table 36 score sums are translated into the risk profiles, which range from the low risk fund to the red flag fund. Scale for the risk level categorization Score sum T A B L E 36 : T H E

Low 1

Good 2

Average 3

High 4

Red flag 5

5 – 25

25 – 50

50 - 75

75 - 100

100 - 125

RISK LEVEL CATEGORIZATION SCALE

The risk profile is categorized in five levels thereof level five is marked as the red flag and automatically falls out of the investment focus. Level one, two and three are favourable investment targets while level four should be preferably avoided or at least examined further before the final investment decision is done. The above scale is just an example of the scoring model. It is purposely conservative for a rigorous fund selection. By doubling the score and placing the weights between the single risk types, e.g. weighting the “internal risks” with 25% and the “statistical indicators and the performance interpretation” with 15% the emphasis can be put on the specific risk type. In general the analysis shall cover the existing and the potential risks inside and outside the fund. The key personnel, their past, present and potential future behaviour and the external risk created by the service providers and the investors are discussed.

Copyright © 2010. Diplomica Verlag. All rights reserved.

7.2

Case LTCM

According to Bacon’s game theory LTCM showed all warning signs and was the part of the game though not recognizing it. The fund operated with US$129bn assets and was significantly larger than any other reporting fund at the end-1997. The aim was to achieve an annual return of 30% applying highly leveraged Fixed Income Arbitrage strategy. The fund’s total OTC derivatives position was at the end-1998 US$1.5trn. The transparency caused even worse problems for the fund, as the market knew the fund’s positions. This fact was the reason enough not to enter the same positions or to trade with LTCM. The market was gone for LTCM as the counterparty. The fund actually was not properly financed as LTCM margined all its capital. Looking at the facts hubris was clearly present in the fund too.169 But not only the Bacon’s warning signs are applicable to LTCM also the market and the operational risk was present. Due to the fund’s size it had to diversify and was operating in almost all main hedge fund styles. The engagement in emerging markets particularly Russia accounted $430 million.170 The combination of the less liquid market and the high leverage 169 Cp. Ineichen, Alexander M. [2000]: In search of Alpha, UBS Warburg, p. 67 170 Cp. Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen-Chancen-Risiken, p. 63

71

offered an opportunity for high returns. But serious problems arose when Russia defaulted on its debt in August 1998. Month’s earlier the investors suffered from the collapse of Asian economies and with Russian default on top prices plummeted daily. Although LTCM was right as end of September prices returned to their fair values the market conditions, the leverage, the margined capital and the fund’s size made the fund collapse.171 A small group of experts priced the assets correctly to their fair value but forgot to take the possible negative impact of the 1998 economical crisis into account, which pushed the asset prices for longer than expected against the LTCM strategy instead of in favour of it. Additionally its positions were larger than 50% of the entire market the fund was invested in. When the risk perspective changed no one was prepared to buy the assets from LTCM as their attitude towards the risk was not the opposite, but the same.172 7.3 Conclusive reflexion The conclusive reflection on the done due diligence should answer whether the potential investment target is a great opportunity or a threat. Besides assessing diverse types of the risk in detail the following questions providing an overall picture of the opportunity should be answered: 1. Who are the people involved? 2. What have they done in the past that would lead one to believe that they will be successful in the future? 3. Who is missing from the team? 4. What is the nature of the opportunity, how will the fund make money? 5. How is the opportunity likely to evolve? 6. What contextual factors will affect the venture?

Copyright © 2010. Diplomica Verlag. All rights reserved.

7. What contextual changes are likely to occur and how can management respond to those changes? 8. What decisions have been made (can be made) to increase the ratio of the reward to the risk?173 The alternative investment funds seem to be more an opportunity than a risk for those who can accomplish thorough due diligence selecting the 171 Cp. Surowiecki, James [2004]: The Wisdom of Crowds, pp. 238-241 172 Cp. Rahl, Leslie [2003]: Hedge Fund Risk Transparency – Unravelling the Complex and Controversial Debate, p. 16 173 Cp. Harvard Business School [1996]: Some Thoughts on Business Plans, p. 27

72

funds, which deliver superior risk-adjusted return.174 Several studies have proven and it is a common perception that in an efficient market the single investor is not smarter than the crowd.175 Since the financial markets exist they have been prone to bubbles. When the bubble bursts the so-called fallacy of composition comes into play. The theorem says that in a crisis the action that is rational for each individual is irrational for the group as a whole, and creates a disastrous outcome. Investors act like the masses in panic pushing towards exit door all at the same time. The rush for the exit causes injuries in the real life and in the financial world.176 Most alternative investment funds unless they are the game do not engage in the bubble peaks as normally they have changed the positions and exited before the panic starts.177 The superior investor will seek to know as much as possible and obtain information about the factors, which are beyond the manager’s control. The investor knowing where the risk lies while understanding the idea of the market and the non-market risk variables provides insight to the potential investment threats.178 Investing in alternative investment fund is about investment philosophies and strategies based on exploiting market inefficiencies while controlling the risk.179 The well-run funds concentrate on the risk management and attempt to control these efficiently, i.e. controlling the risk when the riskreward characteristics of the investment opportunity change.180 When should you invest? 1. You know what you expect from the investment 2. The fund matches your investment policy 3. The fund has a solid set up and the strategy 4. The fund can explain the opportunity 5. The fund is transparent towards the investors

Copyright © 2010. Diplomica Verlag. All rights reserved.

6. The performance and the risk fit your investment mandate

174 Cp. Gregoriou, Greg N. / Hübner, Georges / Papageorgiou, Nicolas / Rouah, Fabrice [2005]: Hege Funds: Insight in Performance Measurement, Risk Analysis and Portfolio Allocation, p. 128 175 Cp. Surowiecki, James [2004]: The Wisdom of Crowds, p. 10 176 Cp. Biggs, Barton [2006]: Hedgehogging, p. 262 177 Cp. Brunnermeier, Markus K. / Nagel, Stefan [2004]: Hedge Funds and the Technology Bubble, (October 2004), In The Journal of Finance, Vol. Lix, No. 5 178 Cp. Swensen, David F. [2000]: Pioneering Portfolio Management, p. 254 179 Cp. AIS Report [October 2000]: Search for Alpha Continues, UBS Warburg, p. 100 180 Cp. AIS Report [March 2005]: The critique of pure alpha, UBS Limited, p. 3

73

7. You have a strong interpersonal relationship with the management team 8. You can establish a balanced relationship between the control, the trust and the support, i.e. the management can collect the money in order to adequately operate within the specific strategy and the investor being able to rely on the management that the capital will be preserved and returned with an attractive profit It is all about understanding present and potential future risks and their management. Nothing is more risky than not being aware what kind of risks you are exposed to and accepting pure randomness. To invest is an “art” based on the skill and experience. There is no perfect model to rely on. The business is based on logical and reflexive thinking as well as strong interpersonal relationships. This foundation creates the conditions for both the manager and the investor to succeed. 7.4 Closing remarks According to Barclaygroup survey AuM reached $1.14 trn by the end of the third quarter 2005 while according to Jones/Strategic Solutions Study it has reached $1.35 trn.181 The Wall Street Journal published on January 3rd 2007, that the alternative investment funds managed approximately $500 bn five years ago, while at the time of the article close AuM reached around $1.44 trn.182 It can be constituted that the growing wealth has a significant influence at the prosperity of the asset management industry. Developing nations like India, China, Malaysia and Thailand are boosting the demand for financial services.183

Copyright © 2010. Diplomica Verlag. All rights reserved.

The alternative investment funds were growing and actively opening to the broader base of the investors. The investors are aggressively seeking the alternative investments and an appropriate alternative risk-adjusted return in comparison to the traditional investments.184 The industry was worldwide rapidly developing over the past decade especially since the internet bubble bust in 2000-2002. Around the 1950s money came exclusively from wealthy individuals and families. Today, the institutional investors predominately pension funds, banks and insurances invest in the alternative investment universe.185 Over the past ten to fifteen years the investors have been looking for the performance. Hence LTCM was considered a great investment returning 181 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, p. 1 182 Cp. Shain, Randy [2008]: Hedge Fund Due Diligence, p. 2 183 Cp. Bergheim, Stefan [2008]: in The Capco Institute, The growth of global wealth until 2020, Wealth - Journal Vol. 15, pp. 129-131 184 Cp. Feiger, George / Botteron, Pascal [2008]: in The Capco Institute, Should you, would you, could you invest in hedge funds?, Alternative Investments - Journal Vol. 10, p. 57 185 Cp. Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, pp. 303-310

74

40% to years running however the basis for that was an extreme leverage. Usually high return means higher risk. George Soros's funds have in the past been very successful in their returns based upon the market timing but have lost substantial amounts when getting the timing wrong, albeit whilst still protecting the capital. The broader range of investors is moving away from the passive investments towards the active asset management. The asset classes’ evolution and opening towards the alternative investments, which were driven by the investors need for an attractive risk-adjusted return as well as the financial education have changed offerings within the asset management industry. Over the past decades we have seen new dimensions of exogenous shocks, terrorism, environmental catastrophes and shortage of commodities. The drawdown hedging has emerged and directed the asset allocation towards the alternative investment industry. The markets and products changed the shape of the asset management industry and induced development of the new business models. A good example for an asset manager changing the dominant rules of the traditional industry is BlackRock. It operates amongst mutual and alternative investment universe and closes the gap between the two industries attempting to provide the positive return combined with the appropriate risk management.186

Copyright © 2010. Diplomica Verlag. All rights reserved.

Myron S. Scholes illustrated an interesting thought about the potential future of the alternative investment industry or moreover the asset management industry in general. “The next decade will produce a revolution in how risk is measured and controlled. The components that must evolve include such diverse issues as how to aggregate risks, how to optimize holdings, how to plan for shocks, how to create a feedback system to learn from outcomes, how to provide information to superiors and the investors, in effect, how to define transparency, how to build appropriate capital structure given the dynamics of the asset mix, and how to compensate employees to mitigate risks.”187 The increased competition, the closing of the information gaps between the investors and the asset management advisors and an increased investor’s price sensibility has changed the perception about what the investor can expect. The investors became aware of three important facts. Firstly, most of the value is generated from the strategy itself, which means the way the things are put together is the essential performance driver. Secondly, there is a growing transparency in the execution quality. Thirdly, tailor-made services are getting more transparent in terms of the pricing and the client is willing to pay for the added value as long as the added value is constantly provided.188

186 Cp. BlackRock [2008]: http://www2.blackrock.com/global/home/AboutUs/index.htm 187 Cit. Scholes, Myron S. [2008]: in The Capco Institute, The future of hedge funds, Alternative Investments - Journal Vol. 10, p. 11 188 Cp. Feiger, George / Shojai, Shahin [2008]: in The Capco Institute, Wealth management in the 21st century: The imperative of an open product architecture, Capital - Journal Vol. 3, p. 74

75

Though alternative investment funds have a long list of advantages the investor has to bear in mind that the industry has a short historical track record compared to the traditional investment industry. From the first alternative investment fund started in 1949 the industry has developed in the past five decades but not yet experienced a longer bear market period. It is not yet proven that the alternative funds are able to generate overall positive returns in the deteriorating markets and also as the performance is dependent on the manager’s skill it is essential that the manager has experienced both, the bull and the bear markets. The high volatility and busting bubbles were present in the past, but we have not yet seen the sustained and adverse condition in the financial markets for a longer duration. The majority of the funds have been formed in the early- to mid-1990s, and since 2000 the industry has been growing at a double-digit paste. This new growth created an exceptionally favourable environment for investment activities, deregulation of the financial services industry, the shareholders demanding a double-digit return, as well as the post internet bubble focus on the alternative investments as the capital preservation instruments enhanced the industry growth pulling AuM to $1.9 trn at its peak.189 It will be interesting to see how the alternative investment funds will perform after the consolidation due to the worldwide credit crisis, which is expected to last at least until the beginning of 2010.190

Copyright © 2010. Diplomica Verlag. All rights reserved.

The fraud case charged against Bernard Madoff illustrates that SEC is not the reliable institution for prosecuting defrauders. Harry Markopolos tried several times to persuade the SEC investigators in Boston and New York that Mr. Madoff’s stated return of 15% was not realistic. But according to Mr. Makropolos SEC seemed to lack the financial expertise needed to understand his warnings or brushed them off and failed to investigate the allegations thoroughly. It seems that Mr. Madoff´s connection and relationship with the regulators helped him to avoid detection as no one has questioned him. He sat on the SEC advisory committee and was the chairman of the Nasdaq Stock Market.191 Mr. Makropols stated that even alerting the media to the violations failed to produce any investigation into Madoff´s actions.192 Bernard Madoff was a result of investors being fooled with the high returns without due diligence into how those returns were made. The investors who concluded the due diligence knew it was impossible for Mr. Madoff to make the returns the fund was reporting it would make. The inefficiencies in the pricing allow skilled managers to achieve great success, while unskilled managers post poor results. Hard work and intelligence reap rich rewards in an environment where superior 189 Cp. Eisinger, Jesse [2008]: The Hedge Fund Collapse, Conde Nast Portfolio, December 2008/January 2009, pp. 143 190 Cp. Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, p. 13 191 Cp. Bloomberg.com [2008]: http://www.bloomberg.com/apps/news?pid=email_en&refer=finance&sid=aN8yfrZr42Kg 192 Cp. Bloomberg.com [2008]: http://www.bloomberg.com/apps/news?pid=email_en&refer=finance&sid=aN8yfrZr42Kg

76

information and business flow provide an edge.193 The alternative investment funds are a people intense business. In most cases the manager is both the opportunity and the threat to the investor. The alternative investment funds that are properly managed are reasonable tools to protect and increase the value of the invested capital. Tools and models do not fit every situation and can often be misused. A clear opportunity for both, the investors and the alternative investment funds is based on trust. The client and the manager must maintain a symbiotic relationship that incorporates trust and financial management. This relationship will result in a win-win situation for both the investor and the fund manager.194

Copyright © 2010. Diplomica Verlag. All rights reserved.

The due diligence is the key to an adequate investment decision-making and is the best prevention against the potential operational risks. The second essential success factor is the reliable relationship and the trust between the alternative investment fund manager and the investors.

193 Cp. Swensen , David F. [2000]: Pioneering Portfolio Management, p. 75 194 Cp. SOUND PRACTICES FOR HEDGE FUND MANAGERS [February 2000]: Sound Practises for Hedge Funds Managers, pp. 1-20

77

Copyright © 2010. Diplomica Verlag. All rights reserved.

Bibliography Agarwal, Vikas / Naik, Narayan Y. [2000]: On taking the “Alternative” Route: Risks, Rewards and Performance Persistence of Hedge Funds, Journal of Alternative Investments, Vol. 2, No. 4, 2000 AIS Report [2004]: European rainmakers, AIS Report April 2004, UBS Investment Research, UBS Limited, London, April 2004 AIS Report [2005]: The critique of pure alpha, AIS Report March 2005, UBS Warburg, London, March 2005 Bergheim, Stefan [2008]: in The Capco Institute, The growth of global wealth until 2020, Wealth - Journal Vol. 15 Bernstein, Peter L. [1998]: Against the gods, the remarkable story of risk, John Wiley & Sons Inc., New York, 1998 Biggs, Barton [2006]: Hedge hogging, John Wiley & Sons Inc., Hoboken, New Jersey, 2006 BlackRock [2008]: http://www2.blackrock.com/global/home/AboutUs/index.htm, (Status: November 2008; Query: 20.11.08; [CET] 15:30) Bloomberg [2008]: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=afAQ U4E6gyA4, (Status: December 2008; Query: 16.12.08; [CET] 07:50) Bloomberg [2008]: http://www.bloomberg.com/apps/news?pid=email_en&refer=finance &sid=aN8yfrZr42Kg, (Status: November 2008; Query: 20.11.08; [CET] 10:30)

Copyright © 2010. Diplomica Verlag. All rights reserved.

Blum, Catherine [2000]: Hedge Funds eröffnen neue Anlagehorizonte, Innovative Kapitalanlagekonzepte, Gabler, Wiesbaden, 2000 Bookstaber, Richard [1996]: “Global Risk Management: Are We Missing the Point?” (Presentation given at the Institute for Quantitative Research in Finance, October 1996, and at the conference on Internal Models for Market Risk Evaluation: Experiences, Problems and Perspectives in Rome, Italy, June 1996.) Brinson, Gary P. / Singer, Brian D. / Beebower, Gilbert L. [1991]: in Financial Analysts Journal 47, no. 3, “Determinants of Portfolio Performance II: An Update”

79

Brunnermeier, Markus K. / Nagel, Stefan [2004]: Hedge Funds and the Technology Bubble, (October 2004), In The Journal of Finance, Vol. Lix, No. 5 Businessdictonary [2008]: http://www.businessdictionary.com/definition/duediligence.html, (Status: December 2008; Query: 20.12.08; [CET] 14:35) Choudhry, Moorad [2006]: An introduction to Value-at-Risk, West Sussex fourth edition, 2006 Christory, Corentin / Daul, Ste´phane / Giraud, Jean-Rene´ [2007]: Quantification of Hedge Fund Default Risk, EDHEC Risk and Asset Management Research Centre, Nice January 2007 Cottier, Philipp [2000]: Hedge funds and managed futures: performance, risks, strategies, and use in investment portfolios, 3. unveränderte Auflage, Bern; Stuttgart; Wien; Haupt: 2000 Die Welt [2008]: http://www.welt.de/finanzen/article2338879/Rund-9Milliarden-Euro-Steuergeld-retten-die-IKB.html, (Status: April 2009; Query: 24.04.09; [CET] 10:45) DW-World [2008]: http://www.dwworld.de/dw/article/0,2144,3729574,00.html, (Status: January 2009; Query: 20.01.09; [CET] 18:40) Economy point [2008]: http://www.economy-point.org/a/alfred-winslowjones.html, (Status: April 2009; Query: 15.04.09; [CET] 22:25) Eisinger, Jesse [2008]: The Hedge Fund Collapse, Conde Nast Portfolio, December 2008/January 2009 Feiger, George / Botteron, Pascal [2008]: in The Capco Institute, Should you, would you, could you invest in hedge funds?, Alternative Investments - Journal Vol. 10

Copyright © 2010. Diplomica Verlag. All rights reserved.

Feiger, George / Shojai, Shahin [2008]: in The Capco Institute, Wealth management in the 21st century: The imperative of an open product architecture, Capital - Journal Vol. 3 Friedrich, Markus / Bahr, Dietmar H. [2003]: Hedge Funds Die Königsklasse der Investments, München, 2003 Financial Times Deutschland [2008]: http://www.ftd.de/koepfe/whoiswho/:Kopf-des-Tages-Comebackdes-Pleitiers-Meriwether/469738.html, (Status: March 2009; Query: 20.03.09; [CET] 10:30)

80

Gregoriou, Greg N. / Hübner, Georges / Papageorgiou, Nicolas / Rouah, Fabrice [2005]: Hedge Funds: Insight in Performance Measurement, Risk Analysis and Portfolio Allocation, John Wiley & Sons Inc., New Jersey, 2005 Harvard Business School [1996]: Some Thoughts on Business Plans, November 14, 1996, No. 9-897-101, Harvard Business School Publishing, Boston, MA02163 Harvard Business School [2001]: Yale University Investments Office: July 2000, Rev. March 4, 2001, No. 9-201-048, Harvard Business School Publishing, Boston, MA02163 Hedges, James R. [2008]: in The Capco Institute, Size vs. performance in the hedge fund industry, Wealth - Journal Vol. 15 Hf-implode [2008]: http://hf-implode.com/ailing/fund_JWMPartnersLLCRelativeValueOpportunityfund_2008-03-27.html, (Status: December 2008; Query: 25.12.08; [CET] 13:10) Hoovers [2008]: http://www.hoovers.com/jwm-partners/--ID__61105--/freeco-profile.xhtml, (Status: December 2008; Query: 25.12.08; [CET] 13:30) Ineichen, Alexander M. [2000]: In Search of Alpha, UBS Warburg, London, 2000 Ineichen, Alexander M. [2000]: Search for Alpha Continues, UBS Warburg, London, 2000 Kaiser, Dieter G. [2004]: Hedgefonds, Entmystifizierung einer Anlageklasse Strukturen - Chancen - Risiken, Wiesbaden, Februar 2004 Kirschner, Sam / Mayer, Eldon / Kessler, Lee [2006]: The Investor’s Guide to Hedge Funds, John Wiley & Sons Inc., New Jersey, 2006

Copyright © 2010. Diplomica Verlag. All rights reserved.

Lavinio, Stefano [2000]: The hedge fund handbook, A definitive guide for analyzing and evaluating alternative investments, McGraw-Hill Companies Inc., New York, 2000 Lehman Brothers [2008]: www.lehman.com/press/pdf_2008/091508_lbhi_chapter11_announ ce.pdf, (Status: January 2009; Query: 19.01.09; [CET] 16:19) Murphy, Don / Hawthorne, Ed [2008]: in The Capco Institute, Operational due diligence in the hedge fund world, Wealth - Journal Vol. 15

81

Nahum, Reiko / Aldrich, David [2008]: in The Capco Institute, Hedge fund operational risk: meeting the demand for higher transparency and best practice, Wealth - Journal Vol. 15 Peetz, Dietmar [2007]: Praktiker-Handbuch Alternatives Investmentmanagement, Stuttgart, 2005 Prime, Didier / Carre, Olivier [2008]: Is UCITS 3 driving the convergence between hedge funds and long-only funds and what are the challenges? AIMA Journal Summer 2008 Porter, Michael E. [1980]: Competitive Strategy, Techniques for Analyzing Industries and Competitors, Macmillan Publishing Co. Inc., New York, 1980 Rahl, Leslie [2003]: Hedge Fund Risk Transparency – Unraveling the Complex and Controversial Debate, Risk Books, Risk Waters Group, London, 2003 Ruggles, Rudy / Holsthouse, Dan / Thurow, Lester [1999]: The Knowledge Advantage. In: Brainpower and the Future of Capitalism, Dover, 1999 Schneeweis, Thomas / Gregoriev, Georgi [2002]: The Benefits of Managed Futures, CISDM/Isenberg School of Management, University of Massachusetts, Amherst (2002) Scholes, Myron S. [2008]: in The Capco Institute, The future of hedge funds, Alternative Investments - Journal Vol. 10 Schumm, Thomas / Lang, Roland [2004]: Hedge Fonds, Alles was Anleger über Investments und Risiken wissen müssen, Finanzbuchverlag GmbH München, 2004

Copyright © 2010. Diplomica Verlag. All rights reserved.

Shain, Randy [2008]: Hedge Fund Due Diligence: Professional Tools to Investigate Hedge Fund Managers, John Wiley & Sons Inc., New Jersey, 2008 Single, Gerhard L. [2001]: Boommarkt Hedge Funds - Initialzündung oder Strohfeuer am Europäischen Kapitalmarkt?, published in “Die Bank”, Edition 7/2001 Soros, George [2008]: The New Paradigm for Financial Markets, Public Affairs New York, 2008 Soros, George [2000]: Open Society: Reforming Global Capitalism, Public Affairs New York, 2000

82

SOUND PRACTICES FOR HEDGE FUND MANAGERS [2000]: Sound Practices for Hedge Funds Managers, New York, February 2000 Strachman, Daniel A. [2007]: The Fundamentals of Hedge Fund Management, How to Successfully Launch and Operate a Hedge Fund, John Wiley & Sons Inc., Hoboken, New Jersey, 2007 Surowiecki, James [2004]: The Wisdom of Crowds, Little, Brown, London, 2004 Swensen, David F. [2000]: Pioneering Portfolio Management, THE FREE PRESS, New York, 2000 Taleb, Nassim Nicholas [2005]: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, second edition, updated by the author, 2005 Random House Trade Paperback Edition, New York, 2005 Venzin, Markus / Rasner, Carsten / Mahnke, Volker [2005]: The strategy process, A Practical Handbook for Implementation in Business, Frankfurt am Main, Campus Verlag, 2005 Wall Street Journal [2008]: http://online.wsj.com/article/SB120569598608739825.html?mod=hp p_us_inside_today, (Status: March 2009; Query: 19.02.09; [CET] 18:49) Weber, Thomas [1999]: Das Einmaleins der Hedge Funds: eine Einführung für Praktiker in hochentwickelte Investmentstrategien, Frankfurt/Main; New York: Campus Verlag, 1999

Copyright © 2010. Diplomica Verlag. All rights reserved.

Ziemann, Peter [2008]: hartgeld.com/filesadmin/pdf/Ziemann_WahrheitBear-Stearns-2-Apr-08.pdf, (Status: April 2009; Query: 20.04.09; [CET] 20:12)

83

Autorenprofil

Copyright © 2010. Diplomica Verlag. All rights reserved.

Ingrid Vancas is a senior-level professional in the banking industry with 12 years of experience. She joined SEB AG in July 2002. Since then she has worked in operations, risk management and currently in client relationship management. As account manager for financial institutions she is responsible for servicing and building client relationships as well as managing those while focusing on risk and reward. Her strong interest in the alternative investment funds and the credit analysis encouraged her to develop a framework for risk assessment of an alternative investment fund. The aim was to develop guidance for evaluation and pre-selection of the funds in the business unit. Ingrid holds a BA in Economics from Steinbeis University Berlin and a MBA in Financial Services Industry from Steinbeis University Berlin in cooperation with NYU Stern in New York and SDA Bocconi in Milano.

Unser gesamtes Verlagsprogramm finden Sie unter: www.diplomica-verlag.de

Copyright © 2010. Diplomica Verlag. All rights reserved.

Diplomica Verlag