Dopfel

Managing Hedge Fund RiskThe Quest for Institutional Quality

2005 Risk Management ConferenceSession Five: Risk-Aware Practices and Procedures, Part 2

August 24-26, 2005

Frederick E. Dopfel, Ph.D.Managing Director

Barclays Global Investors

“Waiter, what’s that hedge fund doing in my soup?

“Well, sir, I think it’s the backstroke … ”

Managing Hedge Fund RiskOutline

• Why hedge funds?

• Recognizing hedge fund risk

• Responding to hedge fund risk — minimum requirements for “Institutional Quality”

• Risk-aware practices: How hedge funds fit into the portfolio

Hedge funds Growth in popularity

“What is the wind behind this sail? After all, hedge fund managers typically transact in asset markets similar to those used by traditional managers.”

William Fung, London Business School & David Hsieh, Duke University

Performance 1994-2004Compared to traditional asset classes

CSFB/Tremont Hedge Equity Mkt Neutral

Managed Futures

Long/Short Equity

Global Macro

Fixed Income Arb

Risk Arbitrage

Distressed

Event Driven

Emerging Markets

Convertible ArbitrageFund Index

Russell 2000

S&P 500

Lehman Gov't Credit

MSCI EAFE

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Annualized risk

An

nu

ali

zed

re

turn

s

Source: CSFB/Tremont, MSCI, Russell, S&P, and BGI estimates.Data based on monthly index returns from Jan ’94 to Jan ’04.

Survivorship and mark-to-market biases?

Understanding Hedge Fund Exposures

Separating alpha and beta

Systematic Risk (beta)

Exp

ecte

d re

turn Stocks

Bonds

Any asset class

rf

Hedge funds ?

Diversification with hedge funds?

Warning!

“The diversification argument for hedge funds must be tempered by the lessons of the summer of 1998 when [the Russian default crisis] changed many of these correlations overnight from 0 to 1.

In the physical or natural sciences, such phenomenon are examples of “phase-locking” behavior, situations in which otherwise uncorrelated actions suddenly become synchronized.”

Andrew Lo, M.I.T.

Does finance imitate nature?

• Warning — there could be a fly “phase-locking” in your soup!

East Asian FireflyPteroptyx malaccae

At dusk, swarms of fireflies move from random to synchronous flashing along

the riverbanks of Malaysia

Correlation in “down” marketsPresence of short option strategies

Source: CSFB/Tremont, MSCI, Russell, S&P, and BGI estimates. Data based on monthly index returns from Jan ’94 to Jan ’04.

-10

-5

0

5

10

-10 -8 -6 -4 -2 0 2 4 6 8 10

Russell 3000 Index (monthly returns %)

He

dg

e F

un

d In

de

x(m

on

thly

re

turn

s %

)

Correlation of CSFB/Tremont Hedge Fund Index and Russell 3000 Index Monthly Returns (1994-2004)

Correlation = + 9% in “up” markets

Correlation = + 56% in “down” markets

Hedge fund style? Warning!

“The fact that hedge funds are for the most part unregulated entities and the fact that there are no generally accepted standards for hedge fund style classification means that there are almost unlimited opportunities for individual funds to engage in strategic self misclassification.”

William Goetzmann, Yale University and Stephen Brown, NYU

Asymmetric Beta ExposuresAcross hedge fund styles

-1.00 -0.75 -0.50 -0.25 0.00 0.25 0.50 0.75 1.00

Emerging Markets

Long/Short Equity

CSFB Tremont Index

Distressed

E.D. Multi-Strategy

Event Driven

Risk Arbitrage

Global Macro

Convertible Arbitrage

Fixed Income Arb

Equity Mkt Neutral

Multi-Strategy

Managed Futures

Dedicated Short

Beta

Asymmetric Hedge Fund Betas

Realized Beta Estimates for Up and Down Markets Relative to Russell 300 Index based on Monthly Returns of CSFB/Tremont Hedge Fund Style Indexes, 1994-2004

Down Market

Up Market

Evolution of hedge fundsThe quest for institutional quality

• Hedge funds will evolve to satisfy a broader segment of the institutional marketplace

• Hedge funds will exploit advantages of long-short investing

• To gain further acceptance, hedge funds will become more transparent in separating alpha and beta, definable benchmarks and risk control, i.e. “Institutional Quality” hedge funds

Minimum requirements for “Institutional Quality” hedge funds

• Clear understanding of the hedge fund’s normal portfolio, enabling separation of alpha and beta

• Confidence that the hedge fund has skill to produce a positive expected alpha

INSTITUTIONALINSTITUTIONAL

Where do hedge funds fit?Risk-aware procedures

• Hedge funds in the SAA policy?– Most common approach– Mixing alpha and beta?

• Two recommended approaches:I. “Alpha Overlay” at the total portfolio level

II. “Portable Alpha” in the traditional asset class

I. Hedge funds as “alpha overlay” at total plan level

The efficient frontier and the active frontier contributed by hedge funds

0%

2%

4%

6%

8%

10%

0%

Exp

ecte

d re

turn

2% 4% 6% 8% 10% 12% 14% 16% 18%

Risk

Efficient frontier

Active frontier

active exposure

policy

Active “tail” extends above the efficient frontier

I. Hedge funds as “alpha overlay” at total plan level

Impact of 10% Allocation

to Hedge FundHedge Fund Assumptions(pure alpha)

7.5%

10.0%

Return

Risk 0.75%

1.00%

Alpha

6.50%

9.75%

PolicyBeta

7.25%

9.80%

TotalPortfolio

9.80%1.00%

9.75%

Hedge fund alpha adds only incremental risk to the portfolio so long as “Institutional Quality” process is followed

II. Hedge funds in the asset class

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

Expected active risk

Exp

ecte

d al

pha

Small Value Active

Small Growth Active

Large Growth Active

Large Value Active

Large Cap Enhanced

Small Cap IndexLarge Cap Index

Current Holdings

Hedge fund

Active efficient frontier

The active efficient frontier (blue) shows the highest possible expected alpha at a chosen level of active risk

With skillful selection of hedge funds, the frontier can be dramatically enhanced (green)

Key messagesRisk Aware Practices and Procedures

• Recognize hedge fund exposures – Focus Efforts on “Institutional Quality” only– Prudent evaluation of own skill

• Risk-aware procedures for fitting hedge funds properly into the portfolio– Alpha overlay at the total portfolio level– Portable alpha at the asset class level

• Remember — your investments are like a SOUP! Always think in portfolio terms. Or else

• … there could be a nasty FLY in your soup!

Contact information:

Fred DopfelManaging Director, Client Advisory GroupBarclays Global Investors45 Fremont StreetSan Francisco, CA 94105(415) [email protected]

Reference:

Dopfel, Frederick E. “How Hedge Funds Fit - The quest for institutional quality” Journal of Portfolio Management, Summer 2005.