Hedge Funds, Hedge Fund Beta, and the Future for Both. Clifford Asness. Managing and Founding Principal AQR Capital Management, LLC

Transcription

1 Hedge Funds, Hedge Fund Beta, and the Future for Both Clifford Asness Managing and Founding Principal AQR Capital Management, LLC

2 An Alternative Future Seven years ago, I wrote a paper about hedge funds in general (and ten years ago about whether they actually hedge) I was smart enough to present the pros and cons of hedge fund investing 1

3 An Alternative Future Seven years ago, I wrote a paper about hedge funds in general (and ten years ago about whether they actually hedge) I was smart enough to present the pros and cons of hedge fund investing, i.e., I hedged 2

4 An Alternative Future Seven years ago, I wrote a paper about hedge funds in general (and ten years ago about whether they actually hedge) I was smart enough to present the pros and cons of hedge fund investing, i.e., I hedged The basic conclusion was that something like index funds and hedge funds represent the future, but not yet 3

5 Sources of Portfolio Returns WHAT HEDGE FUNDS SAY WHAT HEDGE FUNDS DO Skill Dynamic Returns Market Returns Active strategies ( alpha ) Unique to certain managers Cynics and believers disagree on its existence Pure value Pure momentum Arbitrage strategies Many agree on return premium Global equities Global bonds Commodities Most agree on return premium 4

6 Two Definitions of Hedge Funds A strategy that: Investment pools that are: Trades relatively liquid assets Unconstrained Unregulated Seeks to make positive average returns over time High fees Illiquid Provides diversification versus traditional stock and bonds markets Non-transparent Supposed to make money all the time Run for rich people in Geneva by rich people in Greenwich A Portfolio Tool A Compensation Structure Source: An Alternative Future. Diversification does not eliminate the risk of experiencing investment losses. 5

7 Hedge Fund Styles Event Driven Convertible Arbitrage Global Macro Fixed Income Arbitrage Equity Market Neutral Long/Short Equity Dedicated Short Bias Emerging Markets Managed Futures 6

8 Return Hedge Funds: The Good News 1. Hedge funds offer a diversifying, positive expected return 2. This can improve almost any portfolio s risk-adjusted return 10% 9% 8% Realized Efficient Frontier Jan 1994 June % Hedge Funds 100% Stocks 7% 6% 100% Bonds Stocks & Bonds Stocks, Bonds & Hedge Funds 5% 2% 4% 6% 8% 10% 12% 14% 16% Volatility Note: We believe index results are exaggerated by illiquidity and survivorship bias, but are in the right direction Source: Hedge Funds: DJ CS Total Hedge Fund Index, Stocks: S&P 500, Bonds: Barclays Capital Aggregate. For illustration only. Past performance is not an indication of future results. Diversification does not eliminate the risk of experiencing investment losses. 7

9 Growth of Hedge Fund Assets $2,200 Hedge Fund Industry AUM (Jan 1990 Jun 2011, billions) $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 Source: Hedge Fund Research Inc. 8

10 The Dark Sides of Hedge Funds (2004) 1. Lags in Mark to Market [Illiquidity] 2. Correlation 3. Momentum Strategies 4. Survivorship Bias 5. Option Writing 6. Performance Fee Option Maximization 7. Taxes 8. Spotty Historical Track Record 9. Hot Money 10. High-Water Mark Abuse 11. Structured / Levered / Guaranteed Products 12. Crowded Strategies Source: An Alternative Future 9

11 High & Rising Correlations Hedge funds have high and increasing levels of passive market exposure Popular Hedge Fund Indices Correlations with MSCI World (Rolling quarterly hedge fund index returns through August 2011) Since Inception 10Yrs 7Yrs 5Yrs 3Yrs Dow Jones Credit Suisse Hedge Fund Index HFRI Hedge Fund Index Source: Dow Jones Credit Suisse Hedge Fund Index (data from January 1994 June 2011) and HFRI Hedge Fund Index (data from January 1990 June 2011). Past performance is not an indication of future results. 10

12 T-Stat Illiquidity Still a Big Problem 5-Year Rolling Regression of HFRI on S&P 500 and Lagged Quarter Graph Below is T-stat on Lagged Quarter Source: HFRI Hedge Fund Index. For illustrative purposes only. 11

13 What Happened in 2008? 1. Spectacular Asset Growth 2. Scaling Up Non-Scalable Strategies Load up on beta (no longer alternative ) Load up on leverage (no longer investment ) Reduce liquidity (no longer marketable ) 3. A Series of Unfortunate Events Market Crisis (prices fall = bad for beta) Financing Crisis (capital evaporates = bad for leverage) Liquidity Crisis (everyone sells = bad for liquidity) 12

14 Still, Not Too Bad Credit Crisis (Jul Mar. 2009) Cumulative Return Last 10 Years (Jul Jun. 2011) Annualized Return S&P % -2% MSCI World -48% 4% Hedge Funds * -19 to -15% +4 to +7% Hedge Funds outperformed equities in the credit crisis, but if you went into the crisis thinking hedge funds were uncorrelated, you had to be somewhat disappointed. * To proxy for the range of hedge fund returns, we use the maximum/minimum of the HFR Fund of Funds Index and the Dow Jones Credit Suisse Hedge Fund Index. For illustrative purposes only. Past performance is not an indication of future results. 13

15 Is There Still an Alternative Future? Hedge Funds have a role in asset allocation if they: 1. Offer positive expected returns 2. Are uncorrelated (or at least low correlation) to markets, especially equities 3. Are relatively liquid (if not please call them something else) Can this be done? 14

16 How Alpha Becomes Beta ALPHA ALPHA TRADITIONAL BETA ALPHA NON- TRADITIONAL BETA TRADITIONAL BETA ALPHA HEDGE FUND BETA NON- TRADITIONAL BETA TRADITIONAL BETA Prior to Equity Indices Traditional Beta introduced Non-Traditional Beta introduced Hedge Fund Beta introduced Returns viewed as alpha Examples: S&P 500 Index Barclays Aggregate Examples: Commodity Indices Real Estate Examples: Merger Arbitrage Convertible Arbitrage Time 15

17 Why Might Alternative Returns Exist? Liquidity Needs Companies need financing on good terms (convertible arbitrage) Supply and demand for capital not always balanced (carry trades) Risk Aversion Investors don t want to wait for mergers to close (merger arbitrage) General aversion to short stocks (short bias) Suboptimal Investor Behavior Slow reaction to news, tendency to sell winners (managed futures) Avoid investments with bad news / poor results (value) Manager Expertise Some people may be able to predict the future better than others Manager craftsmanship 16

18 Hedge Fund Beta We think investors can access many hedge fund strategies through hedge fund betas Hedge Fund Beta is the set of risks shared by hedge fund managers pursuing similar strategies It can be invested in directly at low cost vs. hedge funds Potential Advantages of investing in Hedge Fund Beta Diversified Economically Intuitive Lower Cost / Liquid Transparent Alternative Can be run hedged Diversification does not eliminate the risk of experiencing investment losses. 17

19 Hedge Fund Beta Everywhere Event Driven Convertible Arbitrage Global Macro Fixed Income Arbitrage Equity Market Neutral Long/Short Equity Dedicated Short Bias Emerging Markets Managed Futures 18

20 HF Beta Replication Primary Objective: Strategy Construction: Investment Approach: Building Blocks: Traditional Beta Exposure: Hedge Fund Beta Maximize diversifying returns Bottom-up Dynamic strategies using current information Individual securities Tactical and kept at modest levels Diversification does not eliminate the risk of experiencing investment losses. Hedge Fund Replication High R 2 to hedge fund indices Top-down Regression using prior returns Broad indices Potentially large 19

21 Drawing the Right Lessons Some lessons from the crisis for hedge fund investors: Know where returns come from (alpha, hedge fund beta, market beta) Be conscious of fees for each return source Build a portfolio based on this separation Hopefully these steps pave the way to a brighter alternative future for all of us 20

22 Disclosures The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC ( AQR ) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. This document is subject to further review and revision. There are many risks associated with convertible securities including but not limited to liquidity risk, equity risk, interest rate risk, and credit risk of the underlying bond. Convertible bond securities may be considered illiquid securities, which cannot be sold or disposed of in the ordinary course of business at approximately the prices at which they are valued. Difficulty in selling securities may also result in a loss or may be costly to the portfolio. There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital. 21