Following the dotcom fiasco and post 9/11 chaos, many institutional investors piled into hedge funds as they sought investment stability in a sea of equity volatility (remember those days?). It was a unique era of extraor- dinary demand for alternative investments and hedge
funds were in the driver’s seat. The terms that hedge funds extracted
from investors reflected that great demand. Private Equity/Buyout
Funds, Fixed Income Funds, Credit Funds, Mortgage Backed funds,
CTAs, Equity Long short, Convertible Arb Funds, and Income
funds were just some of the growing number of categories.
Nevertheless, buyer’s regret soon set in and questions bubbled to
the surface. Liquidity, gating, fees, transparency, exposures and
valuations were some of the issues that demanded attention. This
lack of control, lack of information, and lack of response from the
hedge fund manager was unsettling as investors had granted hedge
funds a huge license with a small level of accountability.
Fees were at levels that were not in the experience of endowment
and pension fund trustees and they wondered about paying huge
sums to rich people that made them richer. The fact that all the risk
was born by the investor was galling to some. It didn’t seem to be
a good deal to the investor.
It was still the early days of “Risk Premia,” and investors were
trying to attribute those returns to a market subsector or phenomenon. The idea was to see if there was skill, to see if the strategies
of the individual managers were correlated and to see if the strategy
was sustainable. A high dependence on mean reverting phenomena
or some other market phenomena might permit one to have a
dialogue to see if the strategy can be replicated for pennies rather
than for “2 and 20”. Hedge funds were reluctant to share information about their program. In that era, fees were non-negotiable and
offering documents typically made provision for extra fees for
services that arguably were the investment manager’s responsibility
such as travel, quote machines, analytical staff and extra charges.
In addition, a few astute investors were concerned about securities
pricing protocols, particularly when the trading activity involved
illiquid strategies. Suspect year-end valuations drove unrealistic
performance payouts and many of the illiquid hedge funds had a
highly subjective component to the valuation. In the long-run,
performance would normalize, but the desire for the immediate
payout of performance fees in the short-term created a conflict that
encouraged aggressive valuations. Implicit in these aggressive
valuations was an acknowledgement that market forces could at
any time destroy a winning thesis or methodology.
The Astute Investors’ View
In this era of the early 2000’s, quantitative shops like Sigma were
engaged by large investors to decompose hedge fund returns and
attempt to understand the drivers and return dependencies. Clients
wanted a better understanding of the risks in their investments
Astute investors realized several things very quickly:
In many cases, there is a market phenomenon (or premia)
that accounts for much of a manager’s returns.
One may be able to purchase the market phenomenon in the
form of an index.
One could access a hedge fund manager’s returns with a
managed account for a very small cash outlay while reducing
risk, reducing fees and getting total transparency and liquidity. The
cash efficiency available in the managed account is so important
it’s created a conundrum that institutional investors are still coming
to terms with. This opportunity set, combined with risk premia, has
encouraged a massive re-thinking of risk and return.
How Expensive Is It?
Once you have it (managed accounts), you can make more rational
investment decisions. You can analyze for beta. If you can own the
S&P 500 index or derivative for a cost of 5 basis points or less and
zero cash outlay, a much higher bar is set (one would think) before
one would allocate to illiquid private equity or engage in stock
picking. The use of derivatives is not an academic question. It is
the lifeblood of excess returns. You can’t reliably make your bogey
without it, and in a less than favourable environment, it is the
How does one value the availability of cash & credit lines to
generate complementary return drivers? Posing this question
simply means, “Let’s have a reasonable & informed discussion &
flesh it out.” While many think these discussions are about new
investment tools, the reality is these tools are more than a quarter
of a century old.
The answer is complex, but “established investment orthodoxy” is
grounded in a mythology of skill & probity with measured judgment
put forth by sober, wise people with sufficient gravitas and communication skills to silence the evidence that confronts one on a daily
basis. If we were facts based, we’d realize stock picking doesn’t
reliably beat a simple index.
Why invest cash in trying to generate returns from equities when
you can invest in equity indices without cash and get the same or
better economic effect at lower cost?
That isn’t a trivial question. It is the essence of the question every
pension plan, endowment, family office and investor should have
asked and answered.
Can someone explain to me why these investors are not allocating
on a risk basis and using derivatives & indices that reflect the
market and cost very little, wherever they can? The compunction
to allocate dollars rather than risk is an extraordinary denial of the
last 40 years of financial progress. If one allocates dollars, one is