|
CURRENT NEWS
To expand any headline to view the entire article, simply click on the link, to close the article simply click on the headline again
 Download
Sep-06 Issue of Carbon Copy
TECHNOLOGY & SOFTWARE
 HEDGE
FUNDS TURN TO TECHNOLOGY TO COPE WITH PAIN POINTS
|
(Source: Domain-b.com) -- Traditionally IT vendors have had limited scope to service the lucrative world of the hedge funds, but increasing exposure and regulation are forcing this industry's participants globally to look to technology to ease some of their pain points.
This is according to a new report by independent market analyst Datamonitor Securities Processing in Hedge Funds. It predicts global hedge funds' investment in IT will reach $3.3 billion by 2009. The report, which investigates the technologies being demanded by this industry to cope with new market developments also, reveals opportunities for technology vendors are not restricted to the global hedge funds industry alone but also to service providers such as prime brokers and fund administrators.
The report provides an overview of trends across the global hedge fund industry as well as the actions the major participants are taking to address these issues, both at a business and technology level. The report also forecasts detailed hedge fund and prime brokerage spend by region until 2009.
"The evolution of the hedge fund sector is somewhat inevitable. Hedge funds globally will look to use technology to improve execution capability in the front office as they seek competitive advantage", says Nii Barnor, financials services technology analyst with Datamonitor and author of the study. "In addition, service providers need to raise the bar too by offering enhanced reporting functionality and superior connectivity to clients."
Despite having a relatively poor year in 2004, the global hedge fund industry has rebounded strongly. Datamonitor expects the global market to reach approximately $1.9 trillion in assets under management by 2009.
Hedge funds are beginning to resemble traditional asset managers by placing cost control and efficiency higher in their priorities, as despite the market growing in size - large number of start-ups entering the field, there have also been numerous instances of funds collapsing due to the competitive pressures in the industry.
In tandem with this, the industry is facing increased levels of regulation. Whereas in the past, high net worth individuals dominated the investor base, pension funds and insurance companies have begun to invest in hedge funds. In addition, new investment vehicles such as the emergence of fund of hedge funds provide a greater level of access to the hedge fund sector. Even though the US courts recently threw out the SEC's mandatory rule for hedge funds to register, regulation of the industry to protect investors is still expected to grow and to be determined on a country level.
"The shift of the hedge fund industry into the retail space has prompted an increased focus on execution capability", says Barnor. "The availability of real-time data to enhance the investment decision making process, direct market access (DMA) and algorithms are all key areas hedge funds are beginning to focus on as they search for new trading opportunities."
Firms servicing the industry such as prime brokers and fund administrators are also beginning to suffer from competitive pressures. Whilst traditionally offering custody, clearing and reporting functionality, prime brokers in particular are finding hedge funds demanding more in terms of supporting complex strategies from both a connectivity and operational aspect.
IT spend by prime brokers will be focused on the European and Asian regions in the next few years (Datamonitor estimates it will reach $414m and $194m respectively by 2009), as they attempt to enhance their margin and stock lending systems as well as upgrading settlement systems to process higher volume, more complex instruments being traded by hedge funds. Technology solutions will continue to be driven by the need to retain and capture client order flow.
Fund administrators too will have to update their offerings and will be looking to technology to do this. Barnor says "the technology in demand is a step on from solutions for the mutual fund industry by focusing more on how to provide a consolidated view to cater for the demands of each kind of investor". As the market develops, fund administrators will be pushed to offer customizable real-time reporting with web based user interfaces.
Barnor concludes, "The global hedge funds industry now provides a viable selling point. The substantial growth of this sector is set to continue as Asia and Europe begin to catch up with the US in market size. As these institutions grow and become more mainstream, technology solutions will continuously be demanded. As it progresses, vendors have the opportunity to tailor their solutions to the intricate nature of the hedge fund industry."
|
WALL
STREET SYSTEMS CONNECTS TO MARKIT FOR CREDIT TRADING
| (Source: Company) -- Wall Street Systems, a provider of global treasury and capital markets solutions and services, announced it has integrated Markit Group Limited's (Markit) Credit Default Swap (CDS) and Corporate Bond price data together with Markit RED (Reference Entity Database) for reference entities and obligations within The Wall Street System. The combined solution will enable clients of Markit and WSS to utilize an enhanced credit trading and risk management solution
using the best data sources in the market.
|
REGULATORY & TAX
TAX
UPDATES PROVIDED BY DELOITTE
| IRS Characterizes Prepaid Forward Contract Plus Loan Into a Sale
The IRS has concluded in technical advice that a sale occurs when shares that have been pledged to a counterparty under a variable prepaid forward contract are loaned to the counterparty pursuant to a share lending agreement and are disposed of by the counterparty, notwithstanding Rev. Rul. 2003-7
Tax Court Grants Extension to File Section 475(f) Mark-to-Market Election for Securities Traders
The Tax Court has held that a securities trader was entitled to an extension of time to elect the mark-to-market method of accounting under section 475(f).
To View the Full Report Click Here
|
SEC
ISSUES INTERPRETIVE GUIDANCE FOR SOFT DOLLARS
(Source: RiskCenter.com) -- The Securities and Exchange Commission has issued interpretive guidance on Section 28(e) of the Securities Exchange Act of 1934 which permits investment managers to use client commissions or "soft dollars" to pay for certain brokerage and research services. The Interpretive Release provides a framework to help determine the scope of the products and services that are covered under the statutory safe harbor of Section 28(e) by establishing standards as to what constitutes brokerage and research services.
To View the Full Report Click Here
|
SEC
EYING BROKER-DEALER, HEDGE FUND TIES
|
(Source: AP) -- The Securities and Exchange Commission will be monitoring hedge funds through their dealings with broker dealers, and those relationships will come under more scrutiny, the commission's director of enforcement said Wednesday.
Linda Chatman Thomsen, speaking in New York, said the SEC would be paying attention to whether broker-dealers were ignoring red flags that were readily apparent in their dealings with hedge funds.
"What we're seeing in cases is beyond a blind eye and into aiding and abetting," Thomsen said at a seminar sponsored by the Practising Law Institute. "Activities with hedge funds are going to be something we're going to focus on."
Hedge funds are among the most active traders of stocks, bonds and derivatives. But the SEC lost its already limited ability to directly oversee them in June, when a federal court rejected a controversial rule requiring hedge-fund managers to register with the SEC.
Broker-dealers like Goldman Sachs Group Inc. and Morgan Stanley, which do lots of business with hedge funds and whose activities are regulated by the SEC, may give the commission an indirect look at what funds are up to.
Thomsen said the SEC found out about late trading and market timing in mutual funds by hedge funds through the lens of broker-dealers. And she said broker-dealers should be as quick to report insider trading by large hedge funds as they are to report such trading by smaller investors.
"The regulated entities are our window into hedge funds," Thomsen said. "Everybody's doing business with them. We're going to find out what they're doing through what we can see."
Thomsen also addressed the controversy over backdating of options, saying that attempts to cover up improper activities would trip up some companies: "It's not what you do that gets you into trouble, it's what you do after you did what you did."
She added, "There's not a thing wrong with granting in-the-money options, but shareholders have to say it's OK ... And you have to account for them a certain way." She said compliance procedures need to be updated to deal with changing options practices.
More than 100 cases of suspected backdated options are being investigated, Thomsen said, although she didn't expect all of them to develop into enforcement actions.
"People generally don't like rich people lying and cheating," she said, "and that is how this is resonating."
|
PRIME BROKERS & ADMINISTRATORS
CITIGROUP
OFFERS ASIAN PACIFIC ADMIN SERVICES FOR ALTERNATIVES
| (Source: Asian Banker) -- The Asian Banker reports that Citigroup's Global Transaction Services has launched Alternative Investment Administration Services in Asia Pacific. These services include fund and portfolio accounting, general ledger accounting, shareholder record keeping, corporate secretarial services and customized statements and reports. The service will benefit hedge fund mangers by easing their administration burden. In effect clients will be outsourcing their administration requirements to Citigroup.
The article mentions that this outsourcing, coupled with the front office capabilities, means that in the Asia Pacific region, Citigroup can now provide a comprehensive array of solutions for hedge fund managers, from prime brokerage through to back office administration requirements. Citigroup is a leading provider of Alternative Investment Administration Services around the world and the launch of this servicing capability in Asia Pacific will complement the growth of the Asia Pacific business.
|
DB
TOPS AGAIN
| (Source: RISK) -- Deutsche Bank has beaten JP Morgan into second place for the second year running in Risk’s annual interdealer survey. The German bank performed well across the market, taking first place in interest rate swaps, overnight index swaps and cross-currency swaps, and appearing in the top five of almost every interest rate category. But JP Morgan was close behind Deutsche, with 9.5% of votes compared with the winner’s 10.6%. Goldman Sachs took third place with 9.1% of the overall vote. Michele Faissola, head of global rates at Deutsche Bank in London, foresees the market continuing to consolidate around the big players. “I expect many vanilla products in the financial institutions arena to follow the life cycle experienced in the foreign exchange market, where you had a period of lots of new entrants, which was then followed by huge consolidation. Now, the top three players own more than 50% of the market.” Meanwhile, the London-based interdealer broker Icap came top of the interdealer broker survey, beating rival Tullett Prebon into second place and winning 33 out of 55 categories of interest rate products.
|
HEDGE
FUNDS SAY MORGAN STANLEY IS TOPS
| (Source: Institutional Investor) -- Global hedge funds managers have crowned Morgan Stanley the top prime brokerage in Alpha magazine's second annual awards, edging out Goldman Sachs, which took the top prize in fund administration, and Banc of America Securities in third. Admiral Administration and Morgan Stanley came in a distant second and third in the fund administration category. Chicago-based BDO Seidman was ranked the top accounting firm in every client category: audit, client service, hedge fund expertise, regulatory and compliance and tax. The only Big Four accounting firm to place in the top tier was Deloitte Touche Tohmatsu, at No. 3. The law firm Olgier was named best offshore law firm, while Sidley Austin took the honors in the onshore category. In technology, Goldman Sachs was No. 1 for trade order management; Backstop Solutions Group for investor relations management; Citco Fund Services for portfolio management and accounting; and RiskMetric Group for risk management. The survey represented the choices of more than 1,000 HF management companies, representing a total of more than $1 trillion.
|
OPERATIONS
CREDIT
DERIVATIVES GROW BY 52% IN FIRST-HALF 2006
| (Source: International Swaps and Derivatives Association) -- The credit derivatives market is now worth $26 trillion notional after another six months of rapid growth, according to the International Swaps and Derivatives Association.
The notional amount outstanding of privately negotiated credit derivatives reached $26 trillion in the first half of 2006, up 52% from $17.1 trillion at 2005 year-end, according to Isda’s mid-year 2006 market survey, released at its regional conference in London yesterday. The survey covered credit default swaps on single names, baskets and portfolios of credit and index trades.
Robert Pickel, chief executive officer of Isda, said the figures showed that “the slight slowdown in the second half of 2005 was just a breather, as the growth has well over doubled from mid-year 2005.”
The year-on-year credit derivatives growth rate of 109%, from a mid-year 2005 figure of $12.43 trillion, rises above significant growth in other asset classes. The notional outstanding amount of interest rate derivatives grew by 18% to $250.8 trillion, equivalent to year-on-year growth of 25%.
Interest rate derivatives volumes, which include interest rate swaps, options and cross-currency swaps, grew by 6% in the second half of 2005, following 10% growth in the preceding six months.
The notional outstanding volume for equity derivatives, comprising equity swaps, options and forwards, grew steadily by 15% to $6.4 trillion, representing year-on-year growth of 32%.
|
BUY
SIDE WANTS SIMPLICITY, RESPONSIVENESS FROM BROKERS, VENDORS
(Source: WallStreet & Tech) -- Assembled at the inaugural Advanced Trading Buy-Side Trading Summit in Amelia Island, Fla., traders from several buy-side firms sketched out the trials, tribulations and desires of running a high-technology trading desk for an audience of their colleagues.
The resounding themes among the three panel speakers were that simplicity often wins out over bells and whistles; that responsiveness is as important as speed when it comes to both in-person and technology-driven service, and that technology is changing job descriptions on both sides of the Street.
How much is too much of a good thing? Like a group of soldiers comparing war wounds, each trader tallied the number of screens he had to manage.
Floyd Coleman, co head trader at AXA Rosenberg, said that he has hit his limit with 12 screens. “I need to look at a lot of things; I need to watch cash, my OMS, DMA, market data and IOIs,” Coleman said. “You need some type of dashboard that tells you how it is all coming together, to show you where you stand at any moment in time.” AXA’s solution was to build an in-house integration platform that allowed its traders to manage their multiple screens. Coleman is still adding new applications to the mix, but is determined to use this software to keep the number of screens from expanding. He also said he appreciates the efforts of vendors to incorporate features of other vendor’s products in their own, citing the example of FlexTrade, his execution management system (EMS), which manages all of his algorithms, including those from other providers.
At Bear Stearns Asset Management, where Manny Villar — three screens, going on five — is a credit derivatives trader, the firm uses a vendor platform, Imagine, to integrate trading in all of his products. “The more streamlined it is, the better,” he said.
There is increasing resistance to saturating trading desks with vendor products that require an extra time investment to learn, said Coleman, who noted that his trial period for major software installations has decreased from two years to six months. Coleman was an advisory board member of the failed multimarket trading venture Optimark, which he said “was too complicated for the traders. They want something that can fit on their desks, has an easy interface and gets the job done. People don’t have the time to learn all the bells and whistles.”
In some ways, the buy-sider desire for simplicity when it comes to technology also extends to their personal relationships with brokers. In a trading world moving increasingly toward simultaneous, multi-asset trading, some brokerage houses have reconfigured their sales desks to better suit this trend.
“There are a couple of firms that cover us for everything,” Villar noted. “Goldman is very good at that. They have set up their trading desk so that the guy who trades the S & P [500 index] sits next to the guy who does credit derivatives, who sits next to commodities. Other firms are kind of going toward that model.”
Responsiveness was another resounding theme of the morning. Even high-value information is no good if it comes too late or prevents other work from getting done. For Robert Gauvain, director of U.S. trading at Pioneer Investments — who has five screens on his desk — this applies both to transaction cost analysis (TCA) and algorithmic trading.
Gauvain uses Plexus for his TCA, but the system, which produces a range of reports at a frequency of daily to yearly, is not sufficient to allow him to make same-day decisions. “It takes a while to get the information out, and then six to eight weeks to digest,” Gauvain said. “Real time makes all the difference in the world.”
There is no question that algorithms are fast and efficient, but they are not always responsive. There are still times when it is best to have the ear of a sales trader on the other end of the line, even as an algorithm robotically — perhaps too robotically — works its way through the marketplace.
“Algorithms have to take the role of a sales trader,” said Gauvain, who noted that his firm plans to increase its use of algorithms from 20 percent currently to 50 percent in the coming years. “Things change in course of a day; you have to be able to change what you are doing and react. Right now, there are algorithms where, if you want to cancel and replace an order, you lose your place in the markets — that is five minutes you are not there. You want the algorithm to be a sales trader that you are manipulating.”
The traders also felt that, largely due to the prevalence of technology that is empowering the buy side, the role of the sell-side sales trader is changing, from a simple account manager and sales agent to more of a consultant, who can guide buy-siders through the miasma of options available to them in a market with thinning margins and increasing regulatory demands.
As profits narrow and brokers reduce head count, Guavain noted that many sell-side traders and technologists are now coming over to the buy side. Having observed this trend in combination with the trend toward unbundling of research, Gauvain foresees that “smaller and midtier firms may look at their business models and see that they can get paid without having the trading desk and become more of a boutique.”
Coleman said he believes that technological savvy will be an essential job requirement on both sides of the Street. “On the buy side, the traders of the future will have to be technologically adept,” Coleman said. “They will farm out your job if you are not adept. On the sell side, the only guys on the sales desk who survive will be those who can act as consultants, who know how to use the Hybrid floor, algorithms, etc. ... They will need a whole new skill set.”
|
MANAGERS, FUNDS & PENSIONS
ALL WE CAN SAY IS AMARANTH, OH, AMARANTH, WHAT HAVE YOU DONE!
AUGUST PUTS HEDGE FUNDS BACK ON TRACK FOR DOUBLE DIGIT 2006
INDEX RETURNED +0.97% in August; +6.65% YTD
|
(Source: Company) -- The Greenwich-Van Global Hedge Fund Index (the 'Index') returned +0.97% in August (+6.65% YTD), according to hedge fund index provider Greenwich-Van Advisors, LLC. In comparison, the S&P 500, MSCI EAFE, MSCI EM, Nikkei 225 and the Lehman Brothers Aggregate Bond Index returned +2.38% (5.80% YTD), +2.78% (+14.71% YTD), +2.60% (+11.78% YTD), +4.42% (+0.18% YTD) and +1.53% (+2.16% YTD), respectively in August.
Greenwich-Van Hedge Fund Index Performance at a Glance
|
HEDGE
FUND RATINGS ARE NO SUBSTITUTE
(Source: HedgeFund Focus) -- Following the news that rating agency Standard & Poors is expanding their criteria for rating hedge funds and planning to include funds of hedge funds, Francois Barthelemy, Partner of F&C Partners, the fund of hedge funds business, said: "Hedge funds are already transparent to investment professionals. There is a wide variety of service providers trying to help investors with due diligence on hedge funds. S&P's move is generally a good thing, but at F&C we have made a conscious choice of not using any outsourced services because we believe it is unwise to take short cuts."
"We conduct our own due diligence and we spend an inordinate amount of time and money conducting comprehensive assessments of managers' investment processes and the robustness of their organisations. Just like a strong credit rating on a company doesn't guarantee a strong share price in the future, a rating system for hedge funds is unlikely to replace detailed ongoing reviews.”
Barthelemy said it was right for the National Association of Pension Funds to welcome S&P's move as it would educate pension fund trustees about hedge funds. He said, however, that "hedge funds can increase returns and decrease risk for pension schemes but only if they employ a robust investment process with ongoing risk monitoring and due diligence. That is what funds of hedge funds are designed to provide."
|
RATINGS
ON HEDGE FUNDS POOR GAUGE OF INVESTMENT RISK - US FED
| (Source: AFX News) -- Rating actions on hedge funds by rating agencies will do little in helping investors gauge the merits or demerits of investing in these leveraged investment products and should not be the strong basis for investment decisions, New York Federal Reserve Bank President Timothy Geithner said.
Geithner told a forum on the sidelines of an investor’s conference here that the focus of rating agencies when it comes to hedge funds is principally on their financial structure and basic controls.
He said the rating actions are often not aimed at capturing the leveraged risks which the funds are taking and it is difficult for those actions to gauge the potential losses they might incur in their investment activities.
In the same forum on hedge funds and derivatives and their implications for the financial system, jointly organized by the Hong Kong Monetary Authority and the Hong Kong Association of Banks, incoming Reserve Bank of Australia governor Glenn Stevens also downplayed the significance of the rating agencies' monitoring of hedge funds even as he noted a positive aspect to it.
'I believe it is a small step toward enhancing the transparency of operations of hedge funds,' he said.
Responding to a question on the trend of some financial institutions going into and offering hedge funds to their clients, Glenn said there is interest among customers of these institutions in higher-yielding investment products.
He said he sees nothing wrong if some institutions want to invest in this type of products, but noted that regulators should ensure that capital is not unnecessarily earmarked by financial institutions for these high-yielding products.
In a prepared speech at the forum, Geithner urged continued vigilance by banks and regulators to reduce risks in the financial markets as he noted that the same improvements that have contributed to greater stability in the financial system since the troubles of the late 1990s may also increase the severity of future large shocks.
Glenn said hedge funds can disrupt the efficient functioning of markets if fund operators decide simultaneously to exit or take new positions.
|
RISK MANAGEMENT
MARKET
RISK – HEDGE FUND FIXED-INCOME TRADING VOLUMES SOAR
|
(Source: RiskCenter.com) - The already considerable influence of hedge funds in US fixed-income markets increased last year as hedge fund trading volume soared between Q1 2005 and Q1 2006.
Overall US fixed-income trading volumes — including bonds and derivatives — increased by about 25% in the 12-months covered in Greenwich Associates’ 2006 Fixed-Income Investors Study. Over the same period, hedge fund trading volume in the same products more than doubled.
“As a result of their significant increase in fixed-income trading volume last year, hedge funds now represent an even bigger portion of the overall market,” says Greenwich Associates consultant Tim Sangston. “In several individual products, hedge funds provide so much liquidity that one could say that certain markets could not function efficiently without them. For example, hedge funds now generate 45% of annual trading volume in emerging market bonds, 47% of annual volume in distressed debt, about one-third in leveraged loans and one-quarter high-yield bonds.”
While hedge funds are increasing their profile across US fixed income as a whole, nowhere is their influence greater than in the increasingly important market for credit derivatives — a natural area of hedge fund emphasis given the leverage inherent in the nature of these instruments and the push by hedge funds away from more commoditized products and into areas with higher margins. In the past year, hedge funds accounted for more than 55% of all credit derivatives trading volume, including 60% of total volume in highly liquid “flow” derivatives and a third of volume in structured derivatives products.
The Good and the Bad
As a result of these gains in derivatives and other fixed-income products, hedge funds are getting more attention from dealers than they ever have in the past. “In many ways, they have become the market,” notes Greenwich Associates consultant Peter D’Amario.
From the dealers’ perspective, the new sway of hedge funds comes with many positives. By their nature, hedge funds encourage the sell side toward innovation, especially when it comes to developing products spanning asset classes. The recent proliferation of CDO-type products and structured credit derivatives can be attributed in no small part to the demand by hedge funds for more sophisticated products. The perceived needs of hedge funds also figured heavily in the decision by some major investment banks to remake their research departments, with some drastically cutting back on written research and instead positioning desk analysts alongside traders to feed ideas into top hedge fund clients.
But there are negatives as well to hedge fund dominance. “At the most obvious level, hedge funds are attracting a huge portion of sell-side attention and resources — so much so that many real money managers or institutions with relatively small annual trading volumes have seen their dealer coverage diminish,” says Greenwich Associates consultant Woody Canaday. “In addition, there is the belief widely held among institutional investors and many other observers that hedge funds are increasing systemic risk throughout financial markets in general.”
From the point of view of the hedge funds, the biggest positive in the new order is that it has emerged mainly to cater to their needs. One practical result is that hedge funds, especially the biggest ones, often get the best ideas, first. That does not mean that hedge funds are not concerned about the new dynamic, in particular the proliferation of hedge-fund-like platforms among buy-side and sell-side organizations. Indeed, the proportion of real money managers with their own, in-house hedge fund platforms tripled to nearly 15% from 2005 to 2006. “Institutions are quite open to new options that would allow them to generate additional alpha from this part of their portfolio without increasing volatility,” says Greenwich Associates consultant Dev Clifford. “Many of the biggest US fixed-income managers are looking to capitalize on this willingness to experiment by offering their clients the option of hedge-fund-like accounts.”
A comparable situation among dealers has the potential for conflict on several levels. “Sell-side firms want to cover hedge funds more actively, but at the same time some dealers are looking and acting more like hedge funds themselves,” says Greenwich Associates Hedge Fund Specialist Karan Sampson. “While there has obviously been a strategic shift on the part of several major brokers in favor of hedge fund-like client options and proprietary trading, some dealers might also be feeling pressured to move in this direction simply to hang on to the talented individuals they have in their own organizations who otherwise might tempted to venture out and start hedge funds of their own.”
|
RISK
AND LIQUIDITY IN A SYSTEM CONTEXT
|
(Source: BIS) - In late 2005, the BIS held a workshop on Accounting, risk management and prudential regulation, which brought together a multi-disciplinary group of around 35 external participants including senior accounting practitioners, standard setters, finance academics, supervisors and central bank officials.
This paper explores the pricing of debt in a financial system where the assets that borrowers hold to meet their obligations include claims against other borrowers. Assessing financial claims in a system context captures features that are missing in a partial equilibrium setting. It is possible for spreads to fall as debts rise, as debt-fuelled increases in asset prices and stronger balance sheets reinforce each other. Conversely, it is possible that de-leveraging leads to increases in spreads, as is often observed during crises.
To view the BIS paper in its entirety Click Here
|
RISK
MANAGEMENT FOR INVESTORS: FUNDS OF HEDGE FUNDS
|
(Source: Risk Net) - Lower returns in the hedge fund industry and increasing sophistication among investors are driving some funds of hedge funds to use derivatives - with a few of the largest morphing into multi-strategy hedge funds.
Only a few independent funds of hedge funds will survive the next five years. This view, expressed by Don Putnam, a managing partner at advisory merchant bank Grail Partners in London, is echoed by many analysts in the industry.
The argument is that funds of hedge funds face big hurdles from heightened competition, high correlation to the equity markets and a decline in returns. In addition, some investors, such as endowments, are becoming more comfortable with hedge funds as an asset class, and are more willing to consider direct investment in single-strategy funds. "Our research shows that, among the largest US endowments, future demand for single- and multi-strategy hedge fund managers will outpace that for funds of hedge funds," agrees Lori Crosley, a consultant at Connecticut-based consultancy Greenwich Associates.
Funds of hedge funds suffered outflows of $2.1 billion in the fourth quarter of 2005, according to Chicago-based Hedge Fund Research (HFR). Some analysts viewed this as a signal that the tides are turning - although vast investment capacity meant this trend reversed during the latest investment quarter (April-June 2006), when funds of hedge funds saw inflows of $15.6 billion, according to HFR.
One point of contention is the fee structure. Fund-of-hedge-funds fees often amount to 1-2% of assets under management, and anywhere from 0-10% is charged for performance fees. Add to that the standard hedge fund fee of 2% of assets under management and 20% of performance fees, and there's not much room left for returns above the money market rate. In fact, the average return of HFR's funds-of-hedge-funds composite index, which includes more than 800 funds, was only 3.72% in the first six months of this year. The return on the HFRI fund-weighted composite index was 5.83% in the same period. For July 2006, returns on the fund-of-hedge-funds index were -0.44%, while the hedge fund index returned -0.21%.
Fund-of-hedge-funds managers counter the criticism by pointing to the asset diversification they provide and the comfort they give to investors new to the alternative investment markets. Funds of hedge funds often perform in-depth monitoring and due diligence on the underlying hedge fund managers, giving some reassurance to investors concerned about fraud.
Nonetheless, to differentiate themselves, some funds of hedge funds are turning to derivatives for hedging purposes and alpha generation, while others are changing their business model to look more like multi-strategy funds.
"We can create a portfolio to reduce the risk of higher volatility and correlated performance to the market. As a first step it would be used for hedging purposes, then later to add alpha," says Nic Karageorgis, an assistant fund manager at Thames River Capital, a $9 billion fund of hedge funds in London.
Roxanne Martino, president of the $8 billion Chicago-based fund of hedge funds Harris Alternatives, says the firm manages a portfolio of options, including puts on the S&P 500. Stock index derivatives are used in addition to an allocation to short-selling managers, to hedge against a drop in the equity markets. "If we don't have the proper allocation of short selling, we can periodically put our own overlay on, because we want the beta to be zero," she says. Every month, the firm recalculates the weighting of its portfolio based on estimated exposures found within the underlying hedge funds strategies. For the first half of 2006, Harris Alternatives had an average return of 12.9%, with a standard deviation of 4.6% and a beta of 0.06.
Some funds of hedge funds are even looking at more complex hedging structures. "We've always found that variance swaps were ideal hedges against hedge funds," says Michael Waldron, director of research at $2 billion Cadogan Asset Management in New York. Variance swaps have a payout equal to the difference between realized variance and a pre-agreed strike level, multiplied by the notional value. Waldron says that although the fund hasn't traded variance swaps yet, the product is conceptually the right hedge because hedge funds tend to under-perform when the variance, which is the square of volatility, is increasing. If structured correctly, the swaps would pay off when volatility rises quickly in a short period. The firm is waiting for the market to develop further and for liquidity to increase before entering into variance swap trades, he adds.
Another way funds of hedge funds are using options is through replication strategies. Research by Andrew Lo and Jasmina Hasanhodzic, professors at the Massachusetts Institute of Technology, and Harry Kat, a professor at the London Business School, among others, have found that certain hedge fund strategies can be cloned with a buy-and-hold portfolio of options. In Lo and Hasanhodzic's latest research, they assume the historical returns for each hedge fund in their sample can be decomposed into six major market exposures (currency, corporate bonds, credit, equities, commodities and volatility). They then construct linear clones by regressing a fund's returns on the first five factors, and releveraging the portfolio so the volatility of the clones' estimated returns matches that of the hedge fund. Specifically, they regress monthly returns on the US dollar index, the Lehman Corporate AA Intermediate Bond index, the spread between the Lehman BAA Corporate Bond index and the Lehman Treasury index, the S&P 500 index, and the Goldman Sachs commodity index. Then they multiply the returns by a factor so the volatility of the clone is the same as the volatility of the historical returns.
According to Lo, in three cases the average mean return of the clones was greater than that of the funds: global macro (14.43% versus 11.38%), managed futures (23.47% vs. 13.64%), and funds of hedge funds (8.63% versus 8.25%). He argues that a fund of hedge funds could therefore replace certain underlying hedge fund strategies with a cheaper options portfolio, with triggers built in so that the weights of each index change over time and respond to market conditions. The portfolio could be benchmarked against the Sharpe ratios of a basket of hedge funds. Lo says he has several business ventures with clients who are interested in implementing the replication strategy, although he declined to elaborate. One fund-of-hedge-funds manager suggests the method might be used as an intermediate step to make use of a stagnant cash portfolio.
Perhaps a more important development is that funds of funds are looking more and more like multi-strategy hedge funds. "Instead of one manager outsourcing to different managers, they are taking all strategies in-house," says Harry Liem, a senior associate at Mercer Investment Consulting in Sydney. He argues that this trend makes sense because of the limited capacity of multi-strategy hedge funds - there are only about 50 major funds worldwide, he estimates - and the sheer number of funds of hedge funds. He points to Goldman Sachs Asset Management and Barclays Global Investors' internal funds-of-funds businesses, which offer single-manager, multi-strategy funds.
Pacific Alternative Asset Management Company (Paamco), a $7 billion California-based fund of hedge funds, is one of the first independent funds altering its business structure. It is creating a platform that will enable hedge fund managers to buy into its overall business in a similar manner to multi-strategy hedge funds, according to a source familiar with the project. Normally, funds of hedge funds invest in external hedge funds and have limited control over the underlying investment process or they obtain exposure through managed accounts, where the hedge fund manager replicates the performance of his or her benchmark hedge fund as closely as possible, while complying with the investment guidelines set by the fund of funds. Under the new structure, Paamco will provide seed money and risk management services to emerging hedge fund managers. In return, the hedge fund will give the fund of funds a percentage of its returns. Paamco might also ask the emerging manager to set up a specific fund through which the fund of hedge funds can direct asset allocations. In this way, the fund of hedge funds will be able to quickly add or remove new funds.
Stephen Oxley, a managing director at Paamco in London, explains that there are several ways for emerging managers to start a new business: they can raise their own capital, go to an incubator platform or join a multi-strategy firm. "Another one might be a fund of hedge funds, like Paamco, which invests in emerging managers, offering a manager to start-up its business with institutional client money. That is one of the ways where you might see more of a convergence of funds of hedge funds with multi-strategy managers," says Oxley. Paamco reviews its hedge fund portfolios on a monthly, sometimes weekly, basis.
Proponents argue there are several benefits to this approach: while maintaining the benefits of diversification, multi-strategy funds of this type would cut out the extra layer of fees charged by some funds of funds. Brett Bastin, a London-based partner at Grail Partners, has also shown that multi-strategy funds tend to have smaller drawdowns, or the difference between the highest and the lowest return, compared with funds of hedge funds (see figure 1).
But one head of a hedge fund group at a New York-based bank argues that investors should be cautious of funds of hedge funds using derivatives, or those that are becoming more like hedge funds. "Investing in capital markets is different from investing in a hedge fund," he says. "When you invest in a hedge fund you are trusting the manager to buy, sell and invest in a portfolio of securities. The skills to assess the abilities of a hedge fund manager are different from the skills required to measure the attractiveness of an individual security or a portfolio of securities. Not that it can't be done, but I'd be skeptical."
Furthermore, he believes a good hedge fund manager can move more swiftly to take opportunities in the market compared with a fund of hedge funds or any passive replication approach. He points to the fact that funds of hedge funds rebalance their portfolios by taking signals from the hedge fund market itself. "There's some degree of risk to doing that because they're waiting for other people to make a move before they can make a move."
Carrie McCabe, New York-based president of Financial Risk Management, a $12 billion fund of hedge funds, disagrees. "I like multi-strategy funds because they can fine-tune in the middle of the month, when I can't. However, I'm not sure they do that as actively as some investors think they do."
The biggest issue related to funds of hedge funds, however, may be neither strategic allocation nor fees. In a February 2006 study, Mathieu Vaissie, a portfolio manager at Lyxor Asset Management in Paris, found that many funds of hedge funds destroy value through active management of the underlying funds, so much so that the overall value added by the industry net of fees is about neutral. Vaissie regressed fund-of-hedge-fund returns on exposures to different hedge fund strategies and included an intercept and error term, which together represent funds of hedge funds' active management through market timing and firm-picking.
Within the past few months, Vaissie has set up a distribution model to determine in what way funds of hedge funds destroy the most value - through strategic allocation, tactical allocation or firm-picking. The results of his latest research, which has yet to be published, show funds of hedge funds have the most difficulty at the onset of the investment process, when they try to choose a hedge fund that will match their long-term goals. "By the time you do all the due diligence studies for investing, most of the time it's too late. By the next period, the hedge fund may not create value," he says. "There are very few hedge fund managers that create alpha on a consistent basis. What we see is mainly short-term alpha creation."
|
COMPLIANCE
FSA
FINES LANGTONS LIMITED FOR SYSTEMS AND CONTROLS FAILINGS
| (Source: RiskCenter.com) - The Financial Services Authority (FSA) yesterday fined Langtons (IFA) Limited, a leading UK-based Financial Planning and Pension Consultant, £63,000 for failing to properly apportion roles and responsibilities to its senior management and for not having systems in place to ensure that its advisers were trained and competent. As a result of these failings, customers were potentially put at risk.
Between January 2003 and November 2005, Langtons failed to allocate responsibilities among its senior management effectively. The resulting confusion over senior management roles meant that its systems and controls were inadequate and its business was not compliant. Consequently, Langtons did not have in place key safeguards to ensure its customers were protected.
Langtons failed to determine the training needs of its investment advisers. Furthermore when training was undertaken it was not properly evaluated or recorded. Langtons did not assess the continuing competence of its advisers or ensure that those under supervision were being adequately monitored.
Margaret Cole, FSA director of Enforcement, said:
"Langtons' senior management could not show that they understood or even knew their responsibilities as a regulated business and thereby the firm unnecessarily exposed its consumers to potential risk.
"Responsibility for proper systems and controls and for compliance with rules designed to protect consumers ultimately lies with a firm's senior management, and we expect them to take these responsibilities seriously."
The failings also meant that Langtons' complaints handling procedures were inadequate and it failed to ensure complaints were dealt with independently. Additionally, the approval of its financial promotions was not carried out by a person with appropriate expertise to ensure that they were clear, fair and not misleading.
Langtons' failings were discovered during an FSA visit to the firm rather than through its own systems and controls.
In determining the level of the financial penalty, the FSA took into account that Langtons has engaged an independent consultant to review its compliance arrangements and its financial promotions procedures. By agreeing to settle at an early stage of the investigation Langtons also qualified for a 30% discount, without which the fine would have been £90,000.
|
MARKETING
INDUSTRY
BUZZ: HENNESSEE WOULD SELL DATABASE
| (Source: Hedge Fund Alert) -- Word is circulating that Hennessee Group’s hedge fund database business is in play. Charles Gradante, who runs the embattled New York firm with his wife, E. Lee Hennessee, maintains that he has no plans to seek a buyer for the database. But at the same time, he acknowledged that he was approached by a major financial institution within the past six months about such a deal. Industry insiders insist that Gradante has let it be known that he is willing to listen to offers.
The potential value of Hennessee’s database is unclear. Morningstar this month acquired Investorforce for $10 million, but in addition to hedge fund performance, that database includes extensive information on separate accounts run on behalf of institutional investors. Hennessee’s database contains details on more than 900 hedge fund managers dating back to 1987, including performance figures for now-defunct vehicles run by such stars as Michael Steinhardt and George Soros. That sort of resource could be valuable to a bank that wants to offer its customers a proprietary database, and could draw attention as a particularly rare opportunity to purchase such a product from an independent boutique.
On the other hand, some market players are skeptical that there would be many takers for such an offering, saying the database doesn’t encompass enough managers. Meanwhile, Hennessee is fighting a number of lawsuits. Most notably, DePauw University’s endowment and other clients of the company’s advisory business are suing the firm for recommending that they park millions of dollars with the fraudulent Bayou Management.
Hennessee’s advisory business steers $400 million to $500 million of its clients’ capital into third-party hedge funds — about half as much as it handled prior to the lawsuits. Hennessee is also trying to fend off a bias suit that a former employee filed earlier this year, claiming she was dismissed for being pregnant with the child of a co-worker. “We’re going to win the lawsuits,” Gradante said. “There is no precedent out there that can be used against the Hennessee Group.”
|
PRIVATE EQUITY & VENTURE CAPITAL
PRIVATE
EQUITY & ASSET MANAGEMENT BRIEF
| (Source: Freeman & Co) -- Over the past five and a half years, there have been 32 transactions completed by private equity firms in the asset management space – with the peak of deals in 2003. Of these, 22 (69%) were acquisitions, while ten were private equity-backed management buyouts (MBOs).
Of the two types, private equity-backed MBOs appear to have become more popular and significant since 2002. Two of the larger transactions were completed by Hellman & Friedman, LLC (H&F) – Mondrian Investment Management (AUM $19 Billion) for $199 Million in 2004 and more recently, of Gartmore Investment Management (AUM $47 Billion) for $936 Million in 2006. Other major deals include Rosemont Investment Partners’ investment in Cadence Capital Management (AUM $6 Billion) and Bridgepoint Capital’s investment in Tilney Holdings (AUM $9.4 Billion) in 2005.
On the acquisition side, a recent notable deal was TA Associates’ acquisition of 50% of Numeric Investors LP (AUM $7.5 Billion) for $240 Million. Additionally, in May 2006, there were reports that H&F invested more then $500 Million in Artisan Partners LP for approximately 20-30% of the firm.
|
PAY
PACKAGES RISE AT VENTURE CAPITAL FUNDS
| (Source: Seeking Alpha) -- According to a study by Holt Private Equity Consultants and Dow Jones Private Equity Analyst, compensation packages are up 35% this year for venture capitalists. Not bad, especially considering that that for the year ending March 31, the average return for U.S. VC funds was just 2.1% higher that the S&P 500 (13.8% vs. 11.7%).
On average, managing general partners are making about $2m, senior partners are making $1.5m, and the average employee can expect to earn $777,000. Even with the pay increases, venture capitalist pay packages are still significantly lower than those at hedge funds, where many successful fund managers earn more than $10m.
The increased pay comes despite the fact that the acquisition of VC backed companies slowed in 2005 compared with 2004 ($15.4b vs. $14.4b). According to the study, "much of the increase may have been due to a few very profitable exits.” If the dollar level of deals is falling, why are pay packages rising? According to Dixon Doll, a partner at VC firm DCM, it’s simply supply & demand – the amount of money investors want to invest in VC funds exceeds the “supply” of available fund space.
|
Download
Sep-06 Issue of Carbon Copy
|
 |
|
White Papers
