Earlier today, a conference wrapped up in London featuring some of the big names in the hedge fund replication industry (Bill Fung & David Hsieh – see related news item from today, Lars Jaeger – see related posting, and William Shadwick – see related posting, and others). In case you couldn’t make it to this powwow, you’re in luck. We trained an uncommonly intelligent house fly (he prefers the name “Musca Domestica”) to take notes over the past two days and send them to us by a miniature fly-sized Blackberry. What follows are the Blackberry ruminations of our ‘fly on the wall’ at the world’s leading alternative beta gabfest.
9:00 AM Monday, March 10: “Got in yesterday despite the bad weather back home and a 300 mph jet stream (which also cramped up my wings a little – had to get a wing massage – but don’t worry, I won’t expense that). Nice Sunday afternoon in London though. Saw a Goose and a Black Swan cavorting yesterday in the park across from Buckingham Palace. Bad omen? Daffodils are blooming here, but storm coming in to London today. Miserable this morning. Hopefully send something more interesting about replication shortly.”
10:23 AM: “Peter Norman from AP7 discussed their separation of alpha and beta (see related posting). They get beta for free given its low-cost. Then they pursue alpha through risk budgeting to managers and not through capital allocations. Long positions are funded by short positions. AP7 covers any temporary losses and allows managers to use their credit. Risk allocation is done using a tracking error methodology carried over from their old long-only active management approach. Going forward, contemplating moving to a VaR approach.”
10:43 AM: “Philippos Kassimatis of Barclays indicated that investors are starting to inquire about strategies with a low correlation to equity markets. Barclays have created something called the ‘ebu’ (European borrowing unit) a synthetic ccy that has a zero interest rate. They think it might be useful as a funding mechanism to be used by hedge funds (i.e., Zero-cost funding in exchange for assuming fx risk in the ‘ebu’.)”
12:19 PM: “Terrence Moll of Investec has done research on factor models and various other replication approaches. He is interested in a product that has a low correlation to bonds and equities that will improve the performance of a broad-based balanced portfolio….but he hasn’t found it yet.”
3:31 PM: “Have heard mention of the zero-sum alpha across hedge funds several times. As a well-read Muscas Domesticas, I am sensing that people either haven’t read or are ignoring the Joanne Hill paper discussing the alpha-pie and the fact that hedge funds sometimes extract alpha from a different universe of investors – and therefore are not necessarily net zero-alpha among them. Many presenters discussed the decline of alpha across the broad hedge fund industry. In fact, it seems this is a typical component of a replication marketing presentation. One audience member conjectured that the recent (i.e. last few years) decline in alpha might be related to the lower level of volatility across markets. She suggested the more recent (i.e. last 6 months) higher level of volatility might lead to increased alpha in hedge funds in the future.”
4:07 PM: “Bill Fung showed the dispersion between different replicators. He indicated the sometimes wide divergence of replication products is due to the addition of discretion to these “passive” replicators. Also discussed the tail risk in HFs. Given what has been observed so far through the turbulence of 2007 and 2008; it appears from his interpretation of the analysis that HF’s are better at managing risk in the current environment than they were in ’98 (when I was but a cute little larva). But he said it is only the good managers that are better at managing risk, not the less careful ones. In fact, he warned that the “less careful managers” would be going out of business. Somehow it appears that there has been some adaptation since 1998. However, an audience-member noted that the analysis depends significantly on two data points (Aug of ’98 and ’07). In response, Fung acknowledged that the rarity of such tail events is one of the inherent difficulties in risk management.
5:38 PM: “In the last panel of the day, ‘The contrary view’, Tony Morris of UBS commented on the high correlation between the HFRI Composite and the MSCI World Index. He argued that due to this high equity correlation, the HFRI Composite is not worth replicating (similar to Cliff Asness’ presentation at a sister conference to this one in NYC last fall – just because you can do something doesn’t mean you should- see related posting). He also made a comment that most of the major hedge fund indices don’t deserve to be replicated. He called replicators “the world’s most expensive equity index”. But despite this contrary view, he went on to indicate that there are alternative betas that can add value and investors should get back to basics by trying to build better portfolios.
11:22 PM, Tuesday, March 11, 2008: “A panel of three fund of funds providers had a generally (and not suprisingly) negative view of replication. But they offered some guidance about where replication could add value. For example, a replicator of strategies with long lock-ups, such as an activist, could be used as a hedge when redeeming from an activist fund isn’t possible. Still, they acknowledged that basis risk could be problematic regarding this type of hedge.”
12:34 AM: “Bill Shadwick discussed tail risk in hedge funds. Despite an academic background, he highlighted the importance of a risk measure being practical. He discussed his approach for capturing tail risk (see related posting) and providing an indicator of tail risk as ‘normal’, ‘high’ and ‘extreme’. Also mentioned the problem of the short time history of hedge fund returns and its impact on the accuracy of the kurtosis figure.”
2:50 PM: “A final merged ‘investor/product provider’ panel covered many topics. One was the difference between alternative beta risk premia vs. the mostly-equity based linear factor replicators. The potential oxymoron of an actively vs. passively managed replication approach was also discussed. One panelist said that, as an investor, he views HF’s as getting exposure to traditional beta, alternative beta, and alpha, minus fees.”
4:17 PM: “Alpha Male…the conference is done now…am loading up on leftovers from the conference lunch before the 13 day flight home. Wing damage from the flight over seems to have healed well. But if I don’t make it, please promise you’ll post my comments on AllAboutAlpha.com. This is the fly on the wall, signing off. ”[Reply] 4:18 PM: “Godspeed, fly on the wall.”