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Aima's Roadmap to Hedge Funds

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Aima's Roadmap to Hedge Funds AIMA’S ROADMAP TO HEDGE FUNDS 2012 EDITION BY ALEXANDER INEICHEN, FOUNDER, INEICHEN RESEARCH AND MANAGEMENT AG COMMISSIONED BY AIMA’S INVESTOR STEERING COMMITTEE PRODUCED WITH THE SUPPORT OF DEUTSCHE BANK AIMA’S ROADMAP TO HEDGE FUNDS – 2012 EDITION Table of Contents Foreword ............................................................................................................................... 3 Executive summary .................................................................................................................. 6 Preface ................................................................................................................................. 7 What exactly is a hedge fund? .................................................................................................... 11 Introduction and definition ...................................................................................................... 11 The hedge fund industry ......................................................................................................... 13 Performance .................................................................................................................... 13 Assets under management .................................................................................................... 16 Flow of funds ................................................................................................................... 22 Concluding remarks: what exactly is a hedge fund? ......................................................................... 23 From relative to absolute returns ................................................................................................ 25 Managing tracking risk versus total risk ........................................................................................ 25 What exactly is risk? .............................................................................................................. 28 The boiling frog syndrome .................................................................................................... 29 Risk versus uncertainty ........................................................................................................ 30 What exactly is risk management? .............................................................................................. 32 The musical chairs effect ..................................................................................................... 33 Prevention versus cure ........................................................................................................ 34 Compounding matters ............................................................................................................ 37 Concluding remarks: from relative to absolute returns ..................................................................... 39 Value proposition of hedge funds ................................................................................................ 41 Active versus passive risk management ........................................................................................ 41 The Fundamental Law of Active Management .............................................................................. 45 The idea of asymmetric returns ................................................................................................. 46 Active risk management .......................................................................................................... 50 Applicability and adaptability of skill ....................................................................................... 50 Intellectual property versus adaptability of skill .......................................................................... 52 Concluding remarks: value proposition of hedge funds ..................................................................... 54 Demystifying all hedge funds ...................................................................................................... 56 Myths and misconceptions ....................................................................................................... 56 Myth: all hedge funds gamble ................................................................................................ 56 Myth: all hedge funds always hedge ......................................................................................... 57 Myth: all hedge funds are risky ............................................................................................... 57 Myth: all hedge funds are speculative ....................................................................................... 58 Myth: all hedge funds charge high fees ..................................................................................... 59 Myth: all hedge funds generate strong returns in all market conditions ............................................... 61 Myth: the lesson of LTCM is not to invest in hedge funds ................................................................ 62 Myth: the Madoff fraud is a hedge fund scandal ........................................................................... 63 Myth: all hedge funds increase systemic risk of financial markets ...................................................... 63 Myth: selling short is the opposite of going long ........................................................................... 65 Myth: it’s all alpha ............................................................................................................. 66 Myth: there is no absolute return revolution ............................................................................... 67 Concluding remarks: demystifying all hedge funds .......................................................................... 68 Hedge fund investing ............................................................................................................... 70 Investment process ................................................................................................................ 70 Manager selection and monitoring ........................................................................................... 71 Portfolio selection and monitoring........................................................................................... 73 Fund of hedge funds .............................................................................................................. 80 Investment philosophy of a fund of funds manager ....................................................................... 81 Risk management experience and other intangibles ...................................................................... 82 Hedge fund operations and related third-party partners .................................................................... 90 The role of prime brokers ........................................................................................................ 90 Hedge fund operations and outsourced partners ............................................................................. 91 Impact of Lehman Brothers ................................................................................................... 92 Managed accounts ................................................................................................................. 92 Concluding remarks: hedge fund investing .................................................................................... 94 AIMA’S ROADMAP TO HEDGE FUNDS – 2012 EDITION Strategies ............................................................................................................................. 96 Classifying hedge funds ........................................................................................................... 96 Returns, volatility, Sharpe ratios and all that ............................................................................... 100 Valuation ......................................................................................................................... 102 Leverage .......................................................................................................................... 103 Liquidity .......................................................................................................................... 107 Fat tails ........................................................................................................................... 111 Concluding remarks: strategies ............................................................................................... 117 Closing remarks .................................................................................................................... 119 Hedge funds: risky game or game of risk? ................................................................................... 119 Appendix 1 .......................................................................................................................... 124 The origins of hedge funds ..................................................................................................... 124 Some technical aspects about tail risk ....................................................................................... 128 Failure, survival and the Adaptive Market Hypothesis ..................................................................... 132 Working example of how leverage can be used ............................................................................
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