Hedge Fund Return Sources Alternative Beta Strategies: A new paradigm to the hedge fund industry Dr. Lars Jaeger, Partner Partners Group Table of contents 2 I Alpha versus Beta in hedge fund returns II Implications: Why hedge fund replication is interesting III The two essential approaches IV Core – Satellite portfolios: A new paradigm to hedge fund investing Alpha versus beta in hedge fund returns The hedge fund return puzzle 3 There is a widely held belief that hedge funds earn their returns through the identification of market “inefficiencies” and by superior investment selection, i.e. by producing “alpha”. However … since hedge funds generally trade in the most efficient markets: Is it really plausible that remaining inefficiencies in these markets can provide a steady stream of alpha to the USD 1,500+ billion hedge fund industry? Are hedge fund managers really so much smarter than traditional managers? ThereThere mustmust bebe another,another, hiddenhidden sourcesource ofof returnsreturns drivingdriving aa significantsignificant partpart ofof thethe performancperformancee ofof manymany hedgehedge fundfund strategiesstrategies 1 Alpha versus beta in hedge fund returns Discovering the “atomic structure” of hedge fund returns 4 The model of an atom in 1895 The model of an atom according to modern quantum physics β β α α ε α α α β1 α α β2 β α ε β3 β ε β 4 α α β5 β α α 7 α ε β6 ε α α α The model of returns in a hedge The emerging model of hedge fund portfolio until today fund return sources Alpha versus beta in hedge fund returns Understanding Hedge Fund Returns: A Simple Model 5 Traditional mutual fund Hedge fund Superior: “Alpha” - Security selection α -Market Timing Currency Risk Premium Event Risk Premium Convergence Risk Premium Commodity Risk Premium Alt- Complexity Risk Premium β Market risk Proclaimed Short Vega Risk Premium Hedge Leverage premium alpha Liquidity Risk Premium Term Curve Risk Premium Small Cap Risk Premium β Value Stocks Risk Premium Leveraged proclaimed alpha Credit Risk Premium EmMa Risk Premium Equity Risk Premium Market- One of many investors’ most frequent mistakes is not looking deeper into a hedge fund’s proclaimed alpha. Alpha versus beta in hedge fund returns Traditional Beta vs. Hedge Fund Beta (Alternative Beta) 6 Traditional Beta Hedge Fund Beta (Alternative Beta) Exposure to: Exposure to: Broad equity market Style factors, such as small cap vs. Interest rates (duration) large cap, value vs. growth, momentum (Long/Short Equity, Equity Market Credit risk Neutral) Emerging markets Event risk (Merger Arbitrage) Volatility (Convertible Arbitrage, Volatility Arbitrage) Risks of commercial hedgers in futures markets (Managed Futures) Liquidity risk (Distressed Securities, Fixed Income Arbitrage, Reg D) Spread risk, e.g. carry trades (Global Macro) Exposure to Hedge Fund Beta requires special investment techniques including short selling, leverage, and the use of derivatives. Thus, hedge funds have exclusive access to these Alternative Betas. 2 Alpha versus beta in hedge fund returns Some words of caution : Distinguish between alpha and beta 7 Distinguish „alphas” and „betas” in hedge funds Alpha and beta do not come separately. Often hedge funds come with “phantom alphas” (i.e. beta is sold as alpha) Phantom alphas are not persistent Phantom alphas can even be related to unwanted and uncontrolled systematic risks Unwanted and uncontrolled systematic risks often lead to DI-WORSE-IFICATION History and common sense tells us: The real risk from hedge funds comes from: unwanted and unknown leveraged systematic risk uncontrolled manager related risk (style drifts, faulty operations, fraud, etc.) Table of contents 8 I Alpha versus Beta in hedge fund returns II Implications: Why hedge fund replication is interesting III The two essential approaches IV Core – Satellite portfolios: A new paradigm to hedge fund investing Why hedge fund replication is interesting Hedge Fund Alpha Is Diminishing … 9 The development of alpha (excess return over a rolling linear factor regression) over a 60 month time window for various strategies : 1.0% Equity Hedge Event Driven Merger Arbitrage Convertible Arbitrage 0.8% 0.6% 0.4% 0.2% Monthly alphain percent 0.0% 5 5 02 02 04 04 07 07 l 01 t 01 02 t l 03 04 t l 05 06 r 06 l 06 u k an k u u an u pr Jan 01Apr 01 J O J Apr 02 Jul O Jan 03Apr 03 J Okt 03Jan Apr 04 Jul Ok Jan 0 Apr 0 J Okt 05J Ap J Okt 06Jan A Jul 07Okt 07 -0.2% HFRI Index Replicating Factors EH S&P 500 Russell 2000 BXM Buywrite Index AR(1) AR (1) = Autoregressive factor for tracking of stale pricing ED S&P 500 Russell 2000 CS High Yield Index AR(1) MERFX = Merger fund index MA SMB Russell 3000 MERFX BXM Buywrite Index AR(1) SMB = Small minus Big (Small Cap Factor) Citigroup CA S&P 500 CS High Yield Index AR(1) Convertible Index Data source: HFR, Bloomberg. Calculation: Partners Group 3 Hedge fund return sources Hedge fund returns: Yesterday, today and tomorrow 10 Average Hedge Fund Return Components over Time 14% 12% 10% α (15%) (48%) α 8% 6% Expected return (42%) (35%) (60%) 4% Alt-β α Alt-β 2% Alt-β (35%) M-β (25%) M-β (10%) M-β (30%) 0% 2008-2012 1995-1999 2000 - 2007 βeta = is a risk premia and a compensation for a risk taken αlpha = is the result of a zero-sum game (one’s profit is another’s loss) Why hedge fund replication is interesting Hedge funds in a global portfolio 11 The traditional “Balanced Portfolio” does not include other risk premia that have favorable diversification qualities and generate attractive alternative returns. Commodity Roll Yield risk hedging risk Equity risk Volatility risk Convergence risk Complexity /efficiency risk Momentum risk Traditional investors benefit only from a few risk premia (blue) Value risk available in the market and miss multiple other sources of return! Event risk FX Carry risk Term risk Duration (Bond) Credit risk risk Convergence risk EmMa risk Investors can access other uncorrelated alternative “risk premia” and thus return sources through hedge funds. TheThe realreal benefitsbenefits fromfrom hedgehedge fundsfunds dodo notnot necessarilynecessarily comecome fromfrom accessingaccessing today’stoday’s starstar trader,trader, butbut fromfrom thethe persistepersistentnt benefitsbenefits ofof alternativealternative riskrisk premiapremia Why hedge fund replication is interesting The Issue of Hedge Fund Fees 12 Pay a lot (and even more in the future) for true alpha skill unavailable anywhere else Pay less for systematic exposure to alternative betas, but more than regular stock market beta as extra skills are required Don‘t pay hedge fund fees for Hedge fund fees traditional beta exposure (even when a few short positions are thrown in for credibility) Hedge fund fee structure does not discriminate between skill based performance (alpha) and risk factor compensation (beta) 4 Why hedge fund replication is interesting Fees I: How about saving the manager fee layer? 13 FoF PG ABS Hedge Fund Return Gross of Fees 9% - 18% 9% - 18% Management Fee HF (2%) / PG ABS (1.25%) 2.0% 1.25% Performance Fee HF (20%) / PG ABS (15%) 1.4% – 3.2% 1.2% - 2.5% Hedge Fund Return Net of Fees 5.6% - 12.8% 6.6% - 14.2% Management Fee FoF (1%) 1.0% Performance Fee FoF (10% above US LIBOR) 0.2% - 0.9% FoF Return Net of Fees 4.4% - 10.9% 6.6% - 14.2% Share of Return Payed Off to Investor 90% 80% 70% 60% 50% 40% 30% FoF 20% PG ABS 10% 0% % % % % % 4 6 8 0% 4 8 1 12% 1 16% 1 20% 22% 24% 26% 28% 30% Gross of Fees Return Total fee savings potential: 220 bps – 330 bps p.a. Why hedge fund replication is interesting Fees II: Do you really need to pay asymmetric performance fee in fund of funds? 14 The ABS performance fee is only paid on the netted performance. In contrast, for a portfolio of hedge funds the performance is not netted. Gross Gross Net Performance ABS: Performance Performance combined: After 15% Hedge Fund 1 Hedge Fund After 20% performance performance 2 fees fees +12% +9.6% +5.1% = +3.6% -6% -6% Total fee savings potential: 40 bps – 80 bps p.a. Why hedge fund replication is interesting Fees III: How can you avoid to pay prime brokers excess leverage financing fees 15 ABS typically employ instruments like futures and options that allow exposure to the desired market with only a fractional size of the underlying cash. Therefore cash can be employed several times. Leverage without external borrowing Hedge Fund B ABS pays Libor +45 bps for leverage External borrowing Hedge Fund A excess cash Traditional receives Libor Fund of -35 bps for funds: required collateral excess cash No access to excess cash Average Exposure of Fund of funds Exposure … HF A HF B HF n Total fee savings potential: 40 bps – 80 bps p.a. 5 Table of contents 16 I Alpha versus Beta in hedge fund returns II Implications: Why hedge fund replication is interesting III The two essential approaches IV Core – Satellite portfolios: A new paradigm to hedge fund investing The two essential approaches Modeling Alternative Beta: Two Different Approaches 17 A. Top down: Linear Regression Approach (RFS) Identify Factors Invest Replication through Direct exposure generic (linear) risk to explaining exposure (Replicating factors Factor Strategies - RFS) B. Bottom up: Non-linear rule-based Approach (AltBeta Strategies) Identify Well known Invest Risk Premia ideas With rule-based Identify various Hedge Identified Risk Premia approach like Fund Risk Premia by backed by academic Hedge Funds do analyzing the industry research The two essential approaches 1.