ALEXANDER M. INEICHEN

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1 Absolute returns The Risk and Opportunities of Hedge Fund Investing ALEXANDER M. INEICHEN John Wiley & Sons, Inc.

3 Absolute returns

4 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e- commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, please visit our Web site at

5 Absolute returns The Risk and Opportunities of Hedge Fund Investing ALEXANDER M. INEICHEN John Wiley & Sons, Inc.

6 Copyright 2003 by Alexander M. Ineichen. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. The documents In Search of Alpha Investing in Hedge Funds 2000 and The Search for Alpha Continues Do Hedge Funds Managers Add Value? 2001 are UBS AG, and extracts from these documents are used with the permission of UBS AG. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, , fax , or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, , fax , permcoordinator@wiley.com. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at , outside the United States at or fax Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data: Ineichen, Alexander. Absolute returns : the risk and opportunities of Hedge Fund investing / Alexander Ineichen. p. cm. (Wiley finance series) Includes bibliographical references and index. ISBN (cloth : alk. paper) 1. Hedge funds. I. Title: Risk and opportunities of Hedge Fund investing. II. Title. III. Series. HG4530.I '5 dc Printed in the United States of America

7 To Claudia, Natasha, and Thomas

9 contents Acknowledgments Preface ix xi PART ONE The Hedge Fund Industry 1 CHAPTER 1 Introducing Absolute Returns 3 Appendix: Risk Illusion 56 CHAPTER 2 Myths and Misconceptions 59 Appendix: Press Coverage of Hedge Funds 93 CHAPTER 3 Difference between Long-Only and Absolute Return Funds 98 Appendix: Guatemalan Dentist 132 CHAPTER 4 Advantages and Disadvantages of Investing in Hedge Funds 134 Appendix: On Market Efficiency and Unorthodox Economics 159 PART TWO Risk and Opportunities of Absolute Return Strategies 177 CHAPTER 5 Classification and Performance of Hedge Funds 179 CHAPTER 6 Relative-Value and Market-Neutral Strategies 199 vii

10 viii CONTENTS CHAPTER 7 Event-Driven Strategies 251 CHAPTER 8 Opportunistic Absolute Return Strategies 286 Appendix: Long/Short Controversy 361 PART THREE The Fund of Hedge Funds Industry 369 CHAPTER 9 Industry Overview 371 CHAPTER 10 Advantages and Disadvantages of Investing in Funds of Hedge Funds 401 CHAPTER 11 The Alpha in Funds of Hedge Funds 420 PART FOUR Going Forward 451 CHAPTER 12 Game of Risk or Risky Game? 453 Notes 479 References 484 Index 499 About the Author 514

11 acknowledgments Iowe thanks to so many people that it is difficult to come up with a complete list. A lot of credit for my written research as an analyst and as an author of this book has to be attributed to experienced and prudent investment professionals in the hedge fund industry as well as colleagues in research, prime brokerage, trading, and related areas. I would like to thank Keith Ackerman, Paddy Dear, Arun Gowda, Jens Johansen, William Kennedy, Rob Kirkwood, Scott Mixon, Simon Phillips, and Alan Scowcroft from UBS Warburg; Daniel Edelman and Mike Welch from UBS O Connor; and David Smith from GAM, Michael J. Sacks from Grosvenor Capital Management, Donald J. Halldin, William H. Lawrence, and John L. Sica from Meridian Capital Partners for their invaluable feedback and generous assistance. A special gratitude I owe the team of the Quellos Group, namely Phillip Vitale and Bryan White, for helping me define and clarify my thoughts and for sharing information without which I would be without an edge. A special thanks to my wife, Claudia, and my children, Natasha and Thomas, who have nearly always been there with their support, understanding, and love. ix

13 preface Once upon a time investors took a holistic approach to their investments. Whether individuals or institutions, they would seek to generate returns by balancing stocks, bonds, and cash in a single portfolio. This was the first investment management paradigm. This approach was primarily implemented by the trust department of the neighborhood bank. This paradigm suffered two great weaknesses: mediocre returns and lack of accountability. These weaknesses were the seeds that enabled a whole new investment management industry and a shift to the second paradigm: the relative performance game. Evaluating the success of a manager with the holistic approach was tricky. With the relative return approach, in contrast, clearly measurable passive market indexes provided the benchmark against which performance could be measured and investment managers held accountable. The second paradigm fits nicely with modern portfolio theory (MPT) and seminal academic work on performance evaluation. With a final push from regulatory changes, the ERISA Act of 1974 in particular, the second paradigm firmly established its roots in the United States and elsewhere. However, the introduction of clear and meaningful performance evaluation highlighted one of active management s greatest weaknesses: poor performance. Beating the benchmark became the focus of a negative-sum game where only a small minority of managers outperforms the benchmark on a consistent basis. The introduction of a market benchmark introduced further negative phenomena such as an incentive to focus on asset growth (as opposed to performance), to execute trend following strategies (as opposed to contrarian strategies), and to seek mediocrity (as opposed to meritocracy). Throughout the 1990s it became clear that in the relative return paradigm one cannot win Charles Ellis loser s game, that there are more investment strategies than buy-and-hold, that increased market liquidity allowed efficient replication of major market benchmarks through passive strategies, and that any alpha, once isolated, could be transported onto any liquid market benchmark. As a result, interests between investors and managers had become misaligned. Absolute return strategies are increasingly being embraced by individuals and institutional investors as the third investment paradigm. The absolute return approach seeks to solve some of the issues of the relative return apxi

14 xii PREFACE proach. Investors introduce an absolute yardstick against which managers get measured. This avoids some of the pitfalls of the relative return approach, namely peer-group hugging, search for mediocrity, and misalignment of interests between manager and investor. However, the absolute return approach introduces new issues to be resolved. First, the loose mandate of absolute return managers (i.e., the lack of tracking error constraints) results in a wide dispersion between managers. This means that the costs and risks of manager selection as well as potential benefits are higher with the absolute return approach than with the relative return approach. Second, a paradigm shift (i.e., the introduction of something new) reduces transparency and increases costs. This is an advantage for early adapters picking up a risk premium, but a disadvantage for latecomers. Active asset managers are hired and paid to exploit investment opportunities. Any investment opportunity, to state the obvious, involves risk. Absolute return managers manage money similarly to relative return managers, with the risk-free rate being the benchmark instead of a market index. However, absolute return managers do not hold positions that are passively replicable at low cost. Absolute return managers define risk as total risk, whereas in the relative return paradigm risk is defined relative to a benchmark; that is, risk is defined as active risk. Unlike with relative return managers, the paramount objectives of absolute return managers are avoiding absolute financial losses, preserving principal, as well as actively managing portfolio volatility. Defining risk as active risk means that it is the market that determines the investor s risk, and not the manager. A further difference between the relative return and absolute return approach lies in the opportunity set. Putting it crudely: The absolute manager invests in the full range of investment opportunities whereas the relative return manager does not. An absolute return manager, for example, can hedge unwanted risk, can change risk profile by levering and delevering according to changes in opportunity set, can exploit inefficiencies on the short side, or can explore valuation differences among equal or similar financial instruments. For a skilled asset manager, a greater pool of investment opportunities leads to greater performance. There are also differences in terms of the magnitude of the investment opportunities in addition to differences in the opportunity set. If a relative return manager has a large cap U.S. equity market index as investment benchmark, he or she is forced to exploit inefficiencies in one of the most efficient financial markets in the world. The magnitude of mispricing is unlikely to be large and the cost of finding the inefficiency prohibitively high. All investors define risk as total risk, that is, as destruction of principal or wealth and not being able to meet liabilities. Total risk is like an iceberg (similar to the one shown on the dust jacket of this book) partly measurable

15 Preface xiii (visible) and partly not. Ignoring the invisible portion of an iceberg because of its invisibility is not necessarily a wise risk management decision. Any definition of risk that does not include risk in its entirety is like only worrying about the layout of deck chairs on the Titanic. London, April 22, 2002 ALEXANDER M. INEICHEN, CFA

Hedge Fund. Course STUART A. MCCRARY. John Wiley & Sons, Inc.

Hedge Fund. Course STUART A. MCCRARY. John Wiley & Sons, Inc. Hedge Fund Course STUART A. MCCRARY John Wiley & Sons, Inc. Hedge Fund Course Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North