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Beyond the casino. Alexander M. Ineichen

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ALEXANDER M. INEICHEN is a managing director and global head of AIS Research at UBS Investment Research in Zurich, Switzerland. [email protected]

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n an investor survey by a consultant firm in March 2000, a European chief investment officer was quoted as saying: “No, we don’t [currently invest in hedge funds]! It is completely obvious that hedge funds don’t work. We are not a casino.” The survey was published at the peak of the equity bull market. While this opinion was typical of the attitude toward hedge fund investing during the equity bull market in Europe and elsewhere, perceptions have changed materially during the equity bear market that followed. When we compare the European and United States hedge fund industry, it is important to distinguish between developments with respect to supply (the managers) and demand (the investors). Europe is certainly lagging the United States with respect to supply-side issues; U.S. managers have a much longer and more diverse history. This does not necessarily apply to the hedge fund investor base. Interest among high net worth individuals and family offices both in the United States and Europe goes back many years. The development of this investor segment has been more or less parallel in the new and the old world. The same can be said for funds of funds that invest in hedge funds. The first fund of funds was founded in Switzerland, and the second in the United States. The situation with respect to other institutional investors is more complex. It is probably fair to say that a handful of U.S. endowments were the first to invest in hedge funds in the late 1980s and early 1990s, followed by a handful of European trusts, foundations, insurers, and pension funds. The number of institutions that can be

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classified as early adopters is extremely small on both sides of the Atlantic. Generally speaking, institutional investors in both the United States and Europe started to consider hedge funds for investment only once equity markets were falling, that is, post-March 2000. We describe the history of the European hedge fund scene and some of its quantitative and qualitative industry characteristics. Our primary analysis is of the riskreturn characteristics of two major strategies followed by European hedge fund managers, long-short equity and managed futures.

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INDUSTRY CHARACTERISTICS

Industry characteristics as well as most of our performance analysis are based on data from Eurohedge. With no reporting requirement for hedge funds, most hedge fund databases are an inadequate representation of the whole industry. We estimate that our data capture far

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BRIEF HISTORY OF EUROPEAN HEDGE FUND SCENE

In Europe one should distinguish among Switzerland (early investors), the United Kingdom (preferred manager location), and the rest of Europe. We set the year 1969 as the starting date for Europe’s involvement in the hedge fund industry. Switzerland’s involvement is different from the rest of Europe in two major ways. First, Switzerland is home to the first fund of hedge funds manager in the world, and today still accommodates some of the largest fund of funds managers and other institutional hedge fund allocators. Second, international high net worth individuals who decided, for whatever reason, to park their wealth in Switzerland were early investors in hedge funds. A handful of Swiss institutional investors also made allocations to hedge funds earlier than others elsewhere in Europe.1 In 1969, Georges Coulon Karlweis started Leveraged Capital Holdings for Banque Privée Edmond de Rothschild in Geneva. The idea was to invest in the best managers who could be found, who at the time were concentrated in New York and included the likes of George Soros and Michael Steinhardt. Given that even the best managers had erratic swings in performance, the idea was to smooth returns through diversification. Most industry observers classify this vehicle as the first formal fund of hedge funds structure.2 The first multimanager program, however, had its origin in the United States when Alfred Jones started allocating assets to external managers in 1954. Jones amended his partnership agreement to reflect a formal fund of funds structure only in 1984, when he was 82 years old.3 Listed hedge fund vehicles in Switzerland took off in 1997 when a regulation by the Federal Banking Commission (FBC) relaxed the private placement restrictions. The rest of Europe was dormant by comparison with respect

to hedge fund vehicles. The regulation caused around half a dozen banks and non-bank financial institutions (fund of fund operators) to issue funds of hedge fund vehicles and list these instruments on the Swiss Stock Exchange. Liberalizing regulatory change has recently also taken place in Germany and France, potentially resulting in a similar coming rush as in Switzerland in 1997. In Germany, a new law could increase both retail and institutional investment in hedge funds. Retail investors are now able to invest directly in funds of funds. Previously they could gain exposure only indirectly through certificates linked to a fund of funds. They are still precluded from investing in single managers. Single hedge fund managers should benefit from direct investment by institutional investors, as the new law creates a legal structure for onshore hedge funds. In France, a law passed last August creates contractual funds, or French-domiciled single-manager hedge funds. It should have been finalized by the French regulator in February 2004. Foreign hedge funds will be able to enter French funds of funds for the first time. The new funds of alternative funds require a minimum investment of just 10,000 euro (around USD12,600) but will be subject to approval from the regulator according to rigorous requirements. The United Kingdom established itself early as the location of choice for single hedge fund managers setting up their investment management company. Manager concentration in Europe around London is similar to the concentration in the New York area in the United States. The City of London is traditionally the epicenter of finance, asset management, and brokerage in Europe, similar to Wall Street in New York, and London is a congenial jurisdiction for investment management businesses.4 Until recently, London was one of the few jurisdictions in Europe where a manager could set up an investment management company with an off-shore fund (most often Dublin) without negative tax consequences for the principals, e.g., taxation on unrealized profits. Overall, London has offered the most attractive mix of investor demand, manager requirements, regulatory credibility, and tax code. Moreover, language barriers in London are lower for a global industry such as the hedge fund industry.5

managers with hedge funds exclusively investing in Europe, the European hedge Geographic Breakdown of European Hedge Fund Industry fund industry counted 320 managers running 528 different hedge funds. Assets under Number of Number of Number of management Market share Market share Note that the $4.1 billion estimated share classes funds managers (managers) ( AU M ) (US$m) UK 523 354 213 $76,481 68.9% 77.0% to be managed by U.S. managers dediFrance 68 52 18 8,173 5.8 8.2 cated to Europe is most likely an underesSweden 17 17 14 5,247 4.5 5.3 Spain 8 8 4 4,315 1.3 4.3 timation of the true amount invested by Ireland 20 15 7 1,835 2.3 1.8 U.S. managers in Europe. Numerous U.S. Switzerland 29 26 23 1,094 7.4 1.1 Finland 11 11 4 744 1.3 <1% hedge funds with offices in Europe are Austria 7 6 3 531 <1% <1% not included. Germany 6 6 6 435 1.9 <1% Norway 6 5 5 201 1.6 <1% No one would question the concluNetherlands 4 4 4 120 1.3 <1% sion that the European hedge fund indusMonaco 2 2 1 66 <1% <1% Denmark 1 1 1 49 <1% <1% try is a successful growth story, although Greece 1 1 1 15 <1% <1% primarily because the industry started with Malta 1 1 1 12 <1% <1% Italy 1 1 1 9.0 <1% <1% a very low base just a couple of years ago. Luxembourg 1 1 1 6.0 <1% <1% Exhibit 2 shows the growth of hedge funds Belgium 1 1 1 4.6 <1% <1% Gibraltar 1 1 1 1.8 <1% <1% as well as European hedge fund managers Total ex. US 7 0 8 513 309 99,340 100 100 from 1986 through August 2003. The data US 17 15 11 4,082.6 3.4 3.9 imply an average annual growth rate of Total 725 528 320 103,422 100 100 around 50% for the period from 1990 through 2002 as well as for the period Source: Raw data from Eurohedge. from 1995 through 2002. Given the high historical growth rate, growth in 2001, more than 80% of the European hedge fund marketplace, 2002, and 2003 (through August) was below average. however, and potentially as much as 90%-95%. Yet any If we compare the European hedge fund industry analysis of hedge funds, as many researchers have pointed with the U.S. mutual fund industry by number of funds out, is subject to caveat lector (reader beware). available, the European hedge fund industry has about as As of August 2003, 309 different investment manmany funds today as the U.S. mutual fund industry had agement companies were managing a total of 513 hedge on offer in 1980.6 funds based in geographic Europe. Including multipleThe dominant strategy in Europe is long-short share classes, there were a total of 708 vehicles managed equity in European equities, constituting around a third by European investment managers. These managers were of the whole industry. As of August 2003, there were 173 managing a total of around USD99.3 billion. European equity long-short hedge funds with European This would suggest that European hedge funds manstocks as their underlying market. In terms of assets under age around 15% of the total universe of around USD650 management, this is about a third of the industry, or billion. This market share is roughly in line with recent USD32.6 billion. Macro and managed futures together industry surveys and our own understanding of the global shared around a fourth of the marketplace, with assets marketplace. under management of USD23.9 billion combined. “Report on Alternative Investing” [2003] suggests Concentration of market share by manager as well that the median strategic allocation by European instituas on a single fund level can be quite extreme. In mantional investors has increased from a 2.5% allocation in aged futures, for example, there were 27 managers with 2001 to a 5.0% allocation in 2003. According to respon43 funds managing around USD11.6 billion. Around dents to the survey, strategic allocations are expected to USD7.0 billion (60%) was concentrated in two funds rise to 7.5% by 2005. from the same manager. The second and third managers Exhibit 1 shows a geographic breakdown of the in this category had market shares of 8.8% and 6.4%. European hedge fund industry. The United Kingdom Exhibit 3 categorizes investment management firms dominates the marketplace with a market share of around domiciled in Europe and running hedge funds by strat77% based on assets under management. Including U.S. egy. Of the whole universe of 513 funds, 293 are denom-

EXHIBIT 1

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EXHIBIT 2 Growth in European Hedge Funds 600 (#)

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inated in USD, 178 are in euros, and 42 are in various other currencies. 426 hedge funds were reported open for new investment.7 Exhibit 4 examines the distribution of assets under management by hedge fund as well as investment manager as of August 2003. The distribution looks somewhat similar to the global distribution; that is, a small number of investment managers have a relatively high market share. The 24 managers with more than USD1 billion under management had a market share of 55.4% of the USD103.4 billion universe (U.S. inclusive). The market shares of the top 10 and 20 investment managers (of a total of 320) were 34.1% and 51.0%. The average investment manager in Europe has USD323 million under management, while the median manager manages only USD63.9 million. The average hedge fund is USD196 million, and mean fund size is USD55 million. The top 10 and 20 hedge funds (of the total of 528) in terms of assets under management had market shares of 23.6% and 35.3%. Like their U.S. counterparts, European hedge fund managers also charge fees. From the universe of 513 hedge funds with investment manager located in Europe, we obtained information on fees from 494 funds. From this universe of 494 hedge funds, 439 (89%) hedge funds had a high-water mark. A management fee of 1.5% of funds under management is the most often observed; 183 (37%) of hedge funds charge that sort of amount. The most common performance fee is 20% of profits, only occasionally above a hurdle rate. 442 or 89% of hedge funds charged a 20% performance fee. The median manager in Europe charges a 1.5%

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management fee and a 20.0% performance fee. 174 or 35% of hedge funds have a fee structure of 1.5 + 20.0 while 121 or 24% of funds have a 2 + 20 structure. The highest fee structures are 8 + 25, 4.8 + 20.0, and 1 + 35. Exhibit 5 shows the fee matrix for the 494 hedge funds. The relatively high fees in the hedge fund industry are often debated, and quite often considered too high or, in some circumstances, unacceptable in institutional investment management. The financial literature is not extensive in this regard, but some researchers have found a positive relationship between fees and performance. Liang [1999], for example, finds a positive relationship between returns and incentive fees, fund assets, and lock-up period. Kao [2002] argues that hedge funds produce just enough active return to earn their overall fees, while long-only managers fail to do so. Brown, Goetzmann, and Liang [2003] also find a statistically significant positive relationship of risk-adjusted returns with incentive fees for individual hedge funds as well as fund assets and a significant negative relationship between returns and fund age. The relationship between incentive fees and performance is probably not limited to hedge funds. One could argue that studies examining the relationship between fees and performance in hedge funds are not very meaningful anyway, because the hedge fund data are not audited; nor are data systematically reported to a central independent agency. An examination by Elton, Gruber, and Blake [2003] of incentive fees in the mutual fund industry may be relevant. It indicates that funds with incentive fees exhibit better stock selection ability than funds without incentive fees. The authors also find that funds with incentive fees also have lower expense ratios than funds without incentive fees. We believe there is a strong economic rationale for the principal (the investor) to share some of the value added by the agent (the active asset manager). A growing amount of empirical evidence seems to support this belief. An asymmetric fee structure is not entirely without challenges to the principal. It is the responsibility of the principal to find the balance between the agent’s taking and controlling of risk. One way to face this challenge is to make the agent a principal as well, i.e., an investor in his or her own fund. This way the manager has the incentives of the agent on the up side, i.e., seeking investment opportunities and taking risk, while preserving the loss aversion characteristics of the principal on the down side, i.e., an incentive to control risk when the risk-reward characteristics of the investment opportunity change.8

EXHIBIT 3 Strategy Breakdown of European Hedge Fund Industry Number of funds

Assets under Number of management Market share Market share (US$m) managers (managers) ( AU M )

European L/S Equity Fund 173 Macro Fund 47 Managed Futures/ CTA 43 Fixed Income High Yield Fund 35 CB & Equity Arb Fund 26 Global Equity Fund 36 Mixed Arb Non-Equity Fund 18 Event Driven Non-Equity Fund 18 Stat/ Quant Arb Non-Equity Fund 2 6 Multi Strategy Non-Equity Fund 16 Japan L/S Equity Fund 23 Emerging Mkt Non-Equity Fund 25 Asian L/S Equity Fund 10 US L/S Equity Fund 11 Arbitrage Non-Equity Fund 3 Distressed Debt Fund 1 Quant Equity Fund 1 Japan Non-Equity Fund 1

115 29 27 20 12 25 9 8 13 6 14 15 5 6 2 1 1 1

$32,573 12,275 11,637 11,269 7,021 6,387 4,909 2,603 2,229 2,177 2,013 1,931 1,775 315 165 39 16 6

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L A PERFORMANCE CHARACTERISTICS G ExhibitE 6 compares some performance statistics. We L fund indexes with three proxies for a compare hedge L I strategy: an equity index, a government bond long-only index, rebalanced allocation to 50% equiISandand50%a monthly ties bonds. The observation period is relatively Source: Eurohedge.

only 68 months, from January 1998 through August ITshort, 2003 (for reasons of limited data availability).

This period covers roughly equal periods of an equity bear market (March 2000 through March 2003) and 258

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EXHIBIT 4 180

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TH Equity Long-Short We caution again that all empirical analysis based on hedge fund indexes has its limitations. This is particularly true in long-short equity. First, the hedge fund industry in general is very diverse. As Bookstaber [2003] points out, it is probably safer to define what a hedge fund is not than to define what a hedge fund is. A hedge fund index, therefore, is only marginally representative, even on a strategy level. Some of our exhibits on manager return dispersion will give evidence of this industry characteristic. Second, hedge fund indexes suffer—as various empirical researchers have pointed out—from various statistical biases because of the lack of a performance reporting requirement. Third, in long-short equity, the distinctions among pure market-neutral, quasi-neutral, leveraged short-termists, noise traders, beta merchants, and pure stock-pickers are far from straightforward. Equity-related hedge fund indexes do not capture strategy differentiation very well. Historically the main categories in Europe have been equities-related. These equity-related hedge fund indexes have performed well, with returns of around 15% and volatilities well below 10%. Note that a comparable long-only strategy in the MSCI Europe total return index

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32.8% 12.4 11.7 11.3 7.1 6.4 4.9 2.6 2.2 2.2 2.0 1.9 1.8 <1% <1% <1% <1% <1%

Source: Eurohedge.

an equity bull market. The observation period also includes the Russian debt crisis in 1998, largely considered one of the most difficult for hedge fund managers. All figures in Exhibit 6 are based on monthly total returns in U.S. dollars net of fees, unless stated otherwise. The two sections of Exhibit 6 compare some European hedge fund indexes with a selection of global hedge fund indexes. The two different indexes entail different calculation methodologies as well as slightly different strategy classifications, so a direct comparison therefore has its limitations. Returns from Eurohedge are a median of all managers, while Hedge Fund Research, Inc. (HFRI) calculates returns based on an equally weighted average of all managers in a category. A median approach gives positive as well as negative statistical outliers less of an impact on the index return value.

EXHIBIT 5 Fee Structure Performance fee Management fee < 1% = 1% 1.01 –1.49% = 1.5% 1.51 –1.99% = 2% > 2% Total

< 20% 1 12 0 8 0 1 0 22

= 20% 4 11 3 12 174 12 121 6 442

> 20% 6 5 2 1 0 9 7 30

Total 11 130 14 183 12 131 13 494

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returned less than the dividend yield in the same period. The long-short equity risk-return patterns are similar to the global long-short equity risk-return profiles. The European equity indexes are more comparable to the HFRI equity hedge index in terms of risk-return profiles than to the HFRI equity non-hedge index. Note that the former constitutes equity long-short managers with a small long bias, while the latter is managers with a stronger directional bias toward equity markets. The equity non-hedge index is much more volatile than the equity hedge index because the managers’ portfolios, given the long bias, are more volatile, and the correlations between managers are higher, also a result of the long bias. Exhibit 7 shows the dispersion of returns among European long-short equity funds. This illustration is based on live as well as defunct funds from January 1990 through August 2003. The funds total 230, starting with a single fund in January 1990, ending with 169 in August 2003, and peaking with 184 in December 2002. The plot shows that in any given month the dispersion is wide (as there is no benchmark to hug). The average dispersion between the best and the worst fund between 1998 and August 2003 was 23.2 percentage points per month. The widest dispersion in this five and a half year observation period was 62.8 percentage points in November 1999. When we examine only the 90% range, the average dispersion still remains at 10.9 percentage points per month, with the widest dispersion at 30.7 percentage points in February 2000. Note that there is no correlation between manager dispersion and equity market returns. Exhibit 8 and Exhibit 9 compare long-short equity index returns with a long-only benchmark index from January 1998 through August 2003. Exhibit 8 shows a scatterplot of the Eurohedge European long-short equity index versus the MSCI Europe index as a proxy for a long-

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only strategy, while Exhibit 9 shows the HFRI equity hedge index versus the MSCI World index. The correlation is positive in both cases, but the correlation coefficient in Europe is lower at 0.49, compared to 0.76 for the global indexes in the same period.9 The Eurohedge European long-short equity index has more positive outliers than the regression between the HFRI equity hedge and MSCI World index. It is interesting to note that the outliers between the two index pairs are more or less the same in terms of occurrence date as well as magnitude. The negative outlier is August 1998, following the Russian default on its ruble-denominated debt and the subsequent flight to quality and liquidity squeeze. In Ineichen [2002, 2003b] we argue that loss-averse investors prefer an asymmetric return profile over a symmetric return profile. Because hedge fund managers define risk in absolute terms and not relative terms, and because they are driven by profit and loss and not tracking error considerations, their risk-return profile is more aligned with the loss-averse investor profile than is the traditional benchmarked long-only investment style. Exhibit 10 compares the asymmetric return profile of the European long-short equity index with the more or less symmetric return profile of the MSCI Europe index. The symmetric return profile shows that the average positive return is very similar to the average negative return. A bull market is characterized as a market environment with more positive than negative returns; hence the mean of the return distribution is positive. A bear market is the opposite. An absolute return strategy has as its objective an asymmetric return profile; that is, positive returns when the strategy works and capital preservation when it does not.10 As our observation period January 1998–August 2003 has a similar number of positive as well as negative months, and the extent of the positive as well as negative returns is fairly similar, the compound annual rate of return of the MSCI Europe for this period is only 0.5% if we assume dividends are not taxed and are reinvested in the index (total returns). By comparison, the Eurohedge European long-short equity index compounded at 14.5% per year. This is a big difference, even if we assume a couple of hundred basis points of survivorship bias in the data. What we find more interesting than historical compounding rates of return is the asymmetry of the positive and negative returns as well as the investment philosophy that stands between these two investment strategies (longonly and long-short). The aim of an absolute return strategy is fairly constant positive returns, ideally irrespective of stock market direction. The absolute return investment phi-

EXHIBIT 6 Performance Overview Sharpe ratio Return Volatility ( 5 % )

Europe MSCI Europe JPM Govt Bonds 50% Equity / 50% Bonds EuroHedge Composite Index EuroHedge European Long/Short Equity Euro Index EuroHedge European Long/Short Equity GBP Index EuroHedge European Long/Short Equity US$ Index EuroHedge Global Equity US$ Index EuroHedge Combined Arbitrage Index EuroHedge Convertible & Equity Arbitrage Index US$ EuroHedge Event Driven US$ Index EuroHedge Fixed Income & High Yield US$ Index EuroHedge Macro US$ Index EuroHedge Managed Futures Index EuroHedge Mixed Arbitrage Index EuroHedge Stat & Quant Arb Index

0.46 5.80 3.32

18.70 3.46 9.10

<0 0.23 <0

-0.40 -0.27 -0.28

0.41 -0.36 0.03

-13.15 -1.60 -5.90

-25.54 -4.11 -10.43

11.30 14.03 12.82 14.52 16.81 10.33 14.40 8.67 9.46 5.99 12.86 10.32 7.60

4.54 8.36 7.71 9.00 8.64 2.15 3.42 2.89 3.05 3.14 9.56 2.86 3.90

1.39 1.08 1.01 1.06 1.37 2.47 2.75 1.27 1.46 0.32 0.82 1.86 0.67

2.26 2.39 -0.34 1.97 1.01 0.97 1.89 0.80 -0.24 0.78 0.13 0.69 1.92

5.77 6.77 3.73 6.32 0.98 1.19 7.45 0.35 1.47 2.48 -0.05 1.67 8.94

-1.61 -4.17 -7.46 -5.77 -3.35 -0.26 -0.46 -0.84 -2.22 -1.24 -5.34 -1.34 -1.91

3.16 0.51 2.11 0.92 -2.45 2.99 6.14 1.85 5.12 1.85 -4.56 1.68 0.32

1.09 5.81 3.42

17.24 6.87 9.08

<0 0.12 <0

-0.53 0.35 -0.31

0.09 -0.14 -0.31

-13.32 -3.30 -5.69

-27.87 -6.18 -13.71

9.02 12.57 8.87 6.66 8.93 11.37 9.66 8.02 3.64 9.04 8.28

8.67 10.97 17.31 3.65 3.75 3.59 7.78 4.36 5.07 6.92 12.59

-0.54 2.83 0.26 1.10 -0.51 0.11 0.51 0.48 -3.38 21.39 -0.98 2.95 -1.52 5.27 -2.44 10.15 -2.95 12.43 0.42 0.80 0.11 0.12

-8.70 -7.65 -13.34 -1.67 -5.80 -3.19 -8.90 -5.69 -6.45 -3.70 -8.62

-4.42 -8.30 -21.66 -0.18 1.13 5.25 -4.80 -2.69 -10.40 -2.36 -12.78

World MSCI World JPM Global Bonds 50% Equity / 50% Bonds HFRI Fund Weighted Composite Index HFRI Equity Hedge Index HFRI Equity Non-Hedge Index HFRI Equity Market Neutral Index HFRI Relative Value Arbitrage Index HFRI Convertible Arbitrage Index HFRI Event-Driven Index HFRI Merger Arbitrage Index HFRI Fixed Income: Arbitrage Index HFRI Macro Index CSFB/Tremont Managed Futures

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The second feature is that the value function is conITcave above the reference point and convex below it, which results in the characteristic S-shape. This feature means that people are most sensitive to changes near the 260

reference point. The third feature of the value function in prospect theory is that it is asymmetrical. A loss appears greater to most people than a gain of equal size (see Roy [1952] and Markowitz [1952, 1957]). This characteristic is called loss aversion. The American humorist, Will Rogers, was probably a loss-averse investor: “I’m more concerned about the return of my money than with the return on my money” (www.brainyquote.com). Exhibit 10 shows that the long-short equity index had on average returns of around 1.8% in months when the MSCI Europe was in positive territory and –0.9% in months when the long-only benchmark had a negative return. The average positive and negative returns for the MSCI Europe were 3.9% and –4.3%. By comparison, the positive and negative returns for the MSCI World in the same time period were 3.8% and –4.1%, very similar to the MSCI Europe. The average positive and negative returns for the HFRI

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EXHIBIT 7 Dispersion of Monthly Returns in European Long-Short Equity

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equity hedge index were 2.8% and –2.1%. The superior historical compound annual rate of return of the long-short indexes when compared with long-only proxies stems from not only smaller negative returns but also fewer ones. In the 68 months of the observation period, the MSCI Europe as well as the MSCI World had 36 positive and 32 negative returns, while the Eurohedge European long-short index had 51 positive and 17 negative returns and the HFRI equity hedge index had 43 positive and 25 negative returns. In other words, the superior historical performance of long-short funds versus long-only funds is derived from adopting an investment approach that results in smaller losses as well as fewer losing months. At the most general level, it seems as if hedge funds, on average, try to follow Warren Buffett’s investment philosophy: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1” (“The Forbes Four Hundred Billionaires” [1986]). The measure for capital preservation characteristics most often used in the hedge fund industry is the drawdown measure. The drawdown measures the largest loss from a previous peak in wealth or index level. The drawdown measure is some sort of combination of excess kurtosis and serial correlation; large negative outliers in combination with serial correlation cause drawdowns to be high. One way to visualize drawdowns and compare wealth preservation characteristics is to look at an index as a percentage of its previous all-time high. In Ineichen [2002]

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we call this the underwater perspective, as it measures the index relative to the surface, i.e., the previous wealth level.12 The index therefore is between 0% and 100% by definition. This way of showing an index time series also lets us see the required time period for losses to be recovered. Exhibit 11 compares the underwater perspective of the Eurohedge European long-short equity index and the MSCI Europe. Notice that we are comparing systematic risk with systematic risk. A stock index is a proxy for a portfolio that diversifies stock-specific risk (i.e., idiosyncratic or non-systematic risk), while a hedge fund index is a proxy for a portfolio that diversifies single-manager risk. The greatest drawdowns of these two indexes were –45.6% for the stock proxy and –5.8% for the hedge fund index. We believe this to be a big difference, especially given that we see hedge funds characterized as speculative while mutual funds are marketed as conservative and therefore suitable for J.Q. Public. Given the big difference in drawdowns, we wonder whether it is not in reality the other way around. Not all hedge funds survive. Sometimes hedge funds go out of business. A hedge fund index like the one shown in Exhibit 11 is a measure of systematic risk; that is, it assumes single-manager risk is fully diversified. In the real world, though, investors do not hold a sufficient amount of hedge funds in a category to fully diversify single-manager default risk. The failure rate is therefore of interest to the hedge fund investor.

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Eurohedge European Long/Short Equity (%)

Eurohedge European Long-Short Equity versus MSCI Europe 15 03-1998 12-1999

02-2000

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2

R = 0.2401

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Source: Datastream, Eurohedge.

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HFRI Equity Hedge versus MSCI World 15

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Exhibit 12 shows the last net asset value (NAV) of defunct funds (vertical axis) and the number of months the funds reported returns to Eurohedge. Inception NAV is normalized to 1,000 for all funds. Note that this analysis is somewhat imprecise, as we do not know why a fund closed, and we also do not know whether the last reported return was really the last for the investor. In the period from January 1998 through August 2003, there were 43 funds (57 different share classes) that started reporting and then stopped reporting returns to Eurohedge. This compares with a total of 230 different long-short equity funds, both defunct and surviving. The relationship between 43 terminated funds and the total figure of 230 is occasionally misused as an indication of the

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Managed Futures

Managed futures are actively traded futures and forward contracts on commodities, bonds, equities, and currencies. A managed futures strategy has some history in Europe. Generally speaking, investment in managed futures constitutes only a small part of a typical investor’s portfolio. Managed futures pools have been around for several decades, as have hedge funds. More recently, managed futures have appeared in classification systems of alternative investment strategies (as opposed to alternative investment assets such as private equity, real estate, timber) as a subgroup of hedge funds, as both hedge funds and managed futures are so-called skill-based investment strategies. Evidence in the financial literature of the benefits of

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failure rate in hedge fund space. It is not unheard of that the number of terminated funds relative to the total is assumed as something like a bankruptcy rate, implying that around 20%-25% of the hedge fund industry goes bankrupt, losing all investor capital. The average NAV of the terminated funds was 1,024 at the time the fund was terminated (or stopped reporting returns). This supports the notion that there is a balance between poor performers as well as good performers leaving the database. In other words, it is not only poorly performing funds that stop reporting (as they close shop due to, for example, economic hardship); strong performing funds also stop reporting as they close for new investors, and the incentive to advertise is removed. The median NAV of the 43 terminated funds was 963, but the left tail of the distribution, as with listed stocks, is quite far from the mean. The worst five funds lost 56%, 44%, 24%, 23%, and 23% of initial capital within 16, 45, 17, 22, and 42 months (respectively) from inception to close. The same five funds were underwater (closing NAV relative to highest NAV) by 67%, 60%, 27%, 27%, and 52%. It should go without saying that while these drawdowns are bad in absolute return space, they are relatively moderate compared to drawdowns in the stock market in the same time period. The five most extreme drawdowns between January 1998 and August 2003 were 99%, 98%, 97%, 97%, and 97% as measured by the Dow Jones Stoxx index.13 Overall, there was little concentration of closing European long-short equity funds in terms of date (unlike in the stock market). The five worst funds we mention above terminated reporting in March 1999, August 2001, April 1999, September 1999, and May 2001.

Schneeweis et al. conclude that private commodity pools do not have Asymmetric Return Profile of European Long-Short Equity value as stand-alone investments Average monthly return during Average monthly return during but are worthwhile additions to a 36 positive months for MSCI Europe 32 negative months for MSCI stock and bond portfolio. For sep5 3.9 arate accounts managed by Com4 modity Trading Advisers, Edwards 3 1.8 and Park find benefits as a stand2 1 alone investment as well as an addi0 tion to a diversified portfolio. -1 McCarthy, Schneeweis, and Spur-0.9 -2 gin [1996] find valuable diversifi-3 cation benefits. -4 Whatever the conclusions in -5 -4.3 the academic literature, graphs Eurohedge European Long/Short Equity (14.5% p.a.) MSCI Europe (0.5% p.a.) such as shown in Exhibit 13 seem to suggest some form of diversifiSource: Datastream, Eurohedge. cation in difficult market conditions for equity-biased portfolios. EXHIBIT 11 Some hedge fund allocators consider exposure to Underwater Perspective of European Long-Short Equity managed futures as a form of a long volatility strategy. The 100 idea behind an allocation of managed futures, i.e., a long volatility strategy, is to balance some of the risk of the rel80 ative-value strategies that are largely considered to be short volatility strategies. Weisman [2002, p. 81] calls short volatility strategies “informationless,” defined as strategies that 60 “tend to produce return enhancements over relatively long periods even though they frequently provide no theoretical 40 long-term benefit.” Many relative-value strategies are to some extent selling economic disaster insurance. Fung and Hsieh [1999] 20 provide three explanations why, for example, fixed-income arbitrage (a relative-value strategy) provides equity-like 0 returns with bond-like volatility: 1) fixed-income arbitrage 1998 1999 2000 2001 2002 2003 funds are capturing true mispricings; 2) they are acting as EuroHedge European Long/Short Equity MSCI Europe market makers providing liquidity; and 3) they sell ecoSource: Datastream, Eurohedge. nomic disaster insurance, where the low historical return volatility is consistent with a period over which the gathmanaged futures is mixed to slightly negative. Performance ering of insurance premiums has yet to be tested by a dispersistence on the part of the manager is generally doubted. aster payout. Irwin and Brorsen [1985] find that public commodThe third point can explain the outliers, as insurers ity funds provide an expanded efficient investment frontier. are essentially short volatility. They perform best in calm Conversely, Elton, Gruber, and Rentzler [1987, 1990], markets and worst in volatile markets. Schneeweis, Savanayana, and McCarthy [1991], Irwin, Exhibit 13 shows graphically what these allocators Krukemyer, and Zulauf [1993], and Edwards and Park describe as long volatility characteristics. Although the eco[1996] conclude that publicly offered commodity funds are nomic logic of such an allocation is ambiguous, Exhibit 13 not attractive either as a stand-alone investments or as an shows that at least in the past such an allocation has worked. addition to an equity-bond portfolio. Edwards and Park find Exhibit 13 compares two managed futures indexes private commodity pools are attractive either as stand-alone with the MSCI World index. The graph shows selected investment or as part of a diversified portfolio. Conversely, Average monthly return (%)

EXHIBIT 10

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high correlation is an indication that there is probably little differentiation among managed futures managers located in Europe or elsewhere. Manager differentiation is based more on the tradable universe of financial instruments and markets and investment approach and less on manager location. Exhibit 13 also shows why managed futures are currently in vogue: good past performance. Exhibit 14 compares returns with a long-only proxy, and Exhibit 15 examines the asymmetric return profile of European managed futures. In this case, we compare the alternative investment strategy with a long-only proxy consisting of 50% equities (MSCI Europe index) and 50% government bonds (JPM Europe Government Bond index) with monthly rebalancing, as managed futures is a mixed directional exposure to various financial instruments. The managed futures and equity-bond proxy have similar volatilities of 9.6 and 9.1, respectively. The historical compound annual rate of return of the managed futures index is 12.9% compared to 3.3% for the long-only proxy over the observation period.14 Exhibit 14 is indicative of the notion that managed futures returns are more or less independent of a traditional portfolio of equities and bonds that follows a long-only buy-and-hold investment style. Exhibit 15 shows that the asymmetry of returns we saw in Exhibit 10 for the long-short equity strategy does not appear in the case of managed futures. In other words, the return distribution is more normal than with other hedge fund strategies; i.e., there is less optionality in the historical returns. The superior compound annual return of the managed futures index is derived not from asymmetric

EXHIBIT 12 Closing NAV (Inception = 1,000)

Failure Rate of European Long-Short Equity Funds 2500

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events when the MSCI World lost more than 5% of its value within one, two, three, or four months from 1980 through 2002. We then compare the negative MSCI World return with the performance of the CISDM Trading Advisor Qualified Universe index during the same period. We also add the Eurohedge Managed Futures index for the period from 1998 through September 2002. The correlation coefficient between the MSCI World index and the CISDM Trading Advisor Qualified Universe index for the period from 1980 through August 2003 based on log returns is –0.06. The correlation between the MSCI World and the Eurohedge Managed Futures index for the period from January 1998 through August 2003 is –0.43. The correlation coefficient between the two managed futures indexes in Exhibit 13 is 0.86. This relatively

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Managed Futures in Distressed Market Situations 25 (%) 20 15 9.6 10 5 0 -5 -10 - 11 . 1 -15 -20 -25 -30

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-5.9

-4.1 -6.8

- 11 . 7

International US rates tension > 15% Mar 1980 Jul 1981 Sep 1981

-12.0

-13.0

4.3 1.5 2.4

-8.9 -12.8

-16.1 -19.3

-20.8

-23.7 Mexico Black crisis Monday Dec 1981 - Sep 1987 Mar 1982 Nov 1987

Nikkei weakness Jan 1990 Apr 1990

Gulf war Aug 1990 Sep 1990

US rate rise Feb 1994 Mar 1994

Asian crisis Aug 1997

Russian crisis Aug 1998 Sep 1998

NASDAQ free-fall Sep 2000 Nov 2000

9 / 11 Sep 2001

Accounting scandal Jul 2002 Sep 2002

MSCI World Index CISDM Trading Advisor Qualified Universe Index EuroHedge Managed Futures Index

Source: Datastream, CISDM, Eurohedge.

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EXHIBIT 16

Eurohedge Managed Futures versus Equity-Bond Mix

Underwater Perspective of European Managed Futures

Eurohedge Managed Futures (%)

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are a total of 44 funds, of which 43 were alive as of August 2003.15 The dispersion of returns in managed futures, as one would expect in the absence of a benchmark, is wide. Returns are all over the place. The average dispersions between 1998 and August 2003 are 16.5 percentage points between best and worst, and 10.6 percentage points for the 90% range. The widest dispersion of 28.8 percentage points is in October 1998. This huge dispersion of hedge fund returns is good for diversification purposes. As a matter of fact, we believe the lessened concern of financial regulators around the world with respect to hedge fund investing has a lot to do with a realization that returns of single managers might be all over the place, but it is exactly this feature—the low-correlation characteristics of alternative investment strategies— that allows the construction of conservative portfolios.

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R returns but from fewer negative returns as compared to the O of the observation period, long-only proxy. In the 68 returns T the long-only proxy has 38 positive and 30 negative returns; for the managed futuresLindex the ratio is 45:23. A the underwater perspective of the Exhibit 16 shows managed futuresG index and the equity-bond mix. The latEa pretty fair approximation of the current ter is probably status of L a majority of (equity-heavy) Anglo-Saxon L plans. Most plans have not yet recovered defined-benefit I from the 2000-2002 equity bear market, and, more disIS the rate of recovery is nearly entirely a function turbingly, Source: Eurohedge.

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Source: Datastream, Eurohedge.

Average monthly return during 38 positive months for Equity/Bond

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Equity/Bond Mix

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interest rates and equity market performance (which ITofin itself is primarily a function of interest rates).

Exhibit 17 shows the dispersion of monthly returns graphically, starting with a single fund in June 1986. There

CONCLUSIONS

The European hedge fund industry has a long history of high net worth investing in the asset class and in funds of funds in Switzerland and the United Kingdom. As is true elsewhere in the world, the involvement of institutional investors in absolute return space is relatively new. In terms of numbers of funds available, the European hedge fund industry has about as many funds today as the U.S. mutual fund industry had on offer in 1980. As of August 2003, there were around 309 different investment companies managing around USD99.3 billion in around 708 different absolute return vehicles. This suggests that around 15% of all assets under management of around USD650 billion in the global hedge fund industry is managed by investment managers domiciled in Europe. Hedge fund managers are concentrated in the United Kingdom,

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financial instruments. 1 Sources for our hedge fund hisDispersion of Monthly Returns in European Managed Futures tory include: Peltz [1994, 2001], Cald30% well [1995], Caldwell and Kirkpatrick [1995], Elden [2001], Anson [2002], and Ineichen [2003a]. 20% 2 Second was Grosvenor Partners in 1971, and third was Haussmann Holdings 10% in 1973. 3 From Caldwell and Kirkpatrick [1995]. 0% 4 300 years ago, the European financial epicenter was Amsterdam. In the 18th century, the Dutch had fought success-10% fully against Spain, France, and England and had become the financial center of -20% Europe. Larger countries developed their own shipping and ports. In their military partnerships with England, the Dutch -30% inevitably became the junior partner, so 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 they turned gradually from trade to finance. Source: Eurohedge. Then recurrent crises of overspeculation eventually sapped confidence in Amsterwhere around 77% of assets under management are located. dam. A larger, more stable money market had been developing in Of 309 managers, 213 are located in the United Kingdom. London, which at the end of the century displaced the AmsterThe absolute return investment style with the greatdam market. 5 est allocation in Europe is long-short equity, which has London is also ideally located for managers with global mandates, as it is in the middle of the three main time zones. market share of around 37% based on manager location 6 There were 564 U.S. mutual funds in 1980, according to and 33% based on assets under management. The median data from the Investment Company Institute. The number of European long-short equity manager compounded capmutual funds had increased to 3,079 by 1990 and to 8,256 by 2002. ital at an annual rate of around 14% between January 7 Note that the strategy classification system in Exhibit 3 is 1998 and August 2003. This compares with a total return slightly ambiguous; there is overlap among the categories. Purely of 0.5% for the MSCI Europe. quantitative funds, for example, appear under different headings. Some The second and third most common strategies in purely equity market-neutral funds are classified in long-short equity. 8 terms of assets under management are macro (12.4%) and According to “Report on Alternative Investing” [2003], 23% of the European respondents listed risk, 20% lack of internal managed futures (11.7%). resources, and 17% transparency as the most frequent reason for Performance characteristics of European hedge fund not investing in hedge funds. Illiquidity and high fees were also managers follow the performance characteristics of global mentioned, but less frequently than in 2001. hedge funds. We see, generally speaking, high historical 9 The correlation coefficient between the HFRI equityrisk-adjusted returns as compared to traditional longhedge index and the S&P 500 total return index was 0.72 in the only investment styles, low correlations among managers, same time period. 10 and wide dispersion of returns between managers folNote that Lo [2001] expresses a diametrically opposing lowing the same styles. view, arguing that “risk management is not central to the success of hedge funds,” while “risk management and transparency are essential” for the traditional manager. In Ineichen [2003a] and elseENDNOTES where, we argue it is the other way around. The mandate to manage total or absolute risk in absolute return space remains The author thanks Damian Alexander, Charlotte Burkeman, with the manager. In a benchmark environment, i.e., relative Larry Chen, Alex Ehrlich, Jens Johansen, and Alan Scowcroft for return space, the mandate to manage total risk is with the end invaluable contributions. investor. The benchmarked manager has a mandate to manage risk The views and opinions expressed are his and not necessarily only relative to the benchmark, i.e., tracking risk. those of UBS. UBS accepts no liability over the content of the arti11 Our central hypothesis in Ineichen [2003a] is that the absocle. It is published solely for information purposes and is not to be lute return investment philosophy will become the norm in the field construed as a solicitation or an offer to buy or sell any securities or

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of active investment management as all investors, private as well as institutional, are loss-averse in one form or another. 12 Loss aversion means that investing is similar to swimming: If you dive underwater, you have a strong incentive to reach the surface again in the future. 13 Of the 600 stocks in the DJ Stoxx, 32 (5.3%) had drawdowns greater than 90%. 205 (34.2%) had drawdowns greater than 67%, the highest drawdown from the 43 terminated European long-short equity funds. Note that a stock that has fallen by 97% from its previous all-time high and then recovers at a rate of 8% per year will recover its losses sometime during 2048. 14 Higher-moment distribution statistics and historical drawdowns are shown in Exhibit 6. 15 Note that the one terminated fund returned 45.7% between June 1999 and July 2002.

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Kao, Duen-Li. “Battle for Alphas: Hedge Funds versus LongOnly Portfolios.” Financial Analysts Journal, Vol. 58, No. 2 (March/April 2002), pp. 16-36.

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To order reprints of this article, please contact Ajani Malik at [email protected] or 212-224-3205.

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