Alternative Asset
Management Group
Alternative Investments:
Hedge Fund Industry Review 2004
and Perspectives 2005
Union Bancaire Privée • 96-98, rue du Rhône • 1211 Geneva 1 • Tel. +4122 819 2111
Continued Friendly Growth for Financial Markets
• The world growth will reach 3% in 2005; the US, China and some
emerging lead the growth.
• The US and Chinese demands fuel the supply from the rest of the world.
The industrial cycle remains in a good shape, but the demand varies across
the regions.
• Capex and exports should remain the most dynamic components of GDP.
• Inflation is under control; oil prices remain a source of volatility.
• Private demand and supply are keys in this phase of the cycle; the end of
reflation policy, except perhaps for Japan.
• Policy-mix manages a gradual return to neutral monetary rates and more
balanced budgets.
• Ingredients to the 2005 profit cycle: a mixed of still robust volumes rising
margins and some restructuring.
2
World Scenario: Moderate and Less
Synchronized Growth
GDP YoY%, vol.
World
USA
Asia
Japan
Euroland
Switzerland
2003
2.8
3.1
6.4
1.5
0.4
-0.5
2004
3.9
4.4
7.2
2.6
1.7
1.7
2005
2.9
3.3
6.0
1.0
1.4
1.4
3
Emerging Countries: High Growth to be Managed
• Growth in emerging countries remain on a high level;
structural high growth in demand.
• The high growth trend could generate frictions: stop and go
policies, inflation pressures, mixed results in policy-mix.
• 40% of the world population will be located in India-Asia
area in 2050.
4
Eurozone: Weak and Uncertain Growth
• The industrial cycle shows some revival thanks to
Germany, but on a low basis; The export trend is fueled
by US and Asian demand for capital goods.
• Signs of weakness are still there: a fragile growth in
industry through the countries and a mixed picture in
services.
• Demand side is still too fragile: unemployment is a
concern and structural reforms are made at a low speed.
5
Japan: Finally Some Positive Signs
• A bottom could have been reached in production
after the Q4 slowdown.
• Machinery orders are still booming, thanks to
foreign orders; capex and export will continue to
lead the growth.
• Service industry is in a positive trend: a booming
activity in the business service sector.
• Restructuring in the economy is going on.
6
Balanced Portfolios: Continued Investments in
Bonds and Risky Assets
Neutral
Balanced Portfolio
USD Profile
Euro Profile
Cash
10
5
5
Bonds
45
40
40
Equities
25
25
25
Alternatives
20
30
30
100
100
100
Asset Allocation
% of Total Portfolio
Total
7
Investment Themes
• Japanese stock market
• Emerging and Asian equities
• Gold
• Commodities – natural resources
• Special situation in some emerging
currencies
8
Risks in the Scenario (Again ?)
On the negative side :
• Oil price shock (again?)
• Geopolitics and terrorism (again?)
• A new war
• Systemic risks in the financial sector or specific credit segments.
• World housing markets : a post bubble correction with negative
impact on stocks
• Recession in OECD
• A new crisis in Asia
On the positive side:
• A counter-shock in oil market
• More fiscal or monetary stimulus
• A growth scenario in line with potential in the G7
• A G7 global agreement on currencies
• End of terrorism and stabilization in the Middle East.
9
Record Asset Inflows in 2004
• The hedge fund industry gained US $16.3 billion in net assets during Q4 of 2004
year, the smallest quarterly inflow for the year
• Total net flows for the industry in 2004 were a record $123 billion compared to
$72.2 billion for 2003.
• Total hedge fund universe now estimated at $975 bn, with an additional $300 bn in
privately managed accounts.
• UBP independently estimated to be third largest allocator, with AuM of around
$18.1bn
• Strategies attracting greatest share of net assets in 2004: Long/Short Equity, at £33
bn, Event Driven at 25.7 bn, and Global Macro with $16.7 bn.
• Convertible Arbitrage and Equity Market Neutral strategies saw net outflows during
Q4, largely due to the low volatility environment
• In Equity Market Neutral trading, managers with a fundamental bias performed
better than those with a statistical bent.
Source: TASS
10
Hedge Fund Industry Asset Flows
All Funds
January 1994 - December 2004
11
Hedge Fund Strategy Returns
2004
15
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12
Hedge Fund Strategy Returns
Inception 1993 – December 2004
450
400
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100
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13
Hedge Fund Industry Assets by Strategy
1993 - 2004
ASSETS BY STRATEGY
100%
90%
80%
70%
60%
Global Macro & CTA
50%
Long/Short Equity
Arbitrage / RV
40%
30%
20%
10%
0%
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
14
Major Asset Classes Performances
MSCI Emerging Market Free
NASDAQ Composite Index
MSCI World Price Index
S&P 500 Price Index
Nikkei 225 Index
Euro/USD
Gold Price
MSCI Europe (in Local Currency)
Index
2004
2003
2002
Goldman Sachs US Commodity TR
CSFB/Tremont Hedge Fund Index
-46.00%
-36.00%
-26.00%
-16.00%
-6.00%
4.00%
14.00%
24.00%
34.00%
44.00%
15
VIX Volatility Index
• Of 126 months where the VIX > than 20% 168 bps out-performance of HRF FoF US
where VIX < 20%.
• Mid-level volatility (VIX at 18-25%) is best for hedge funds
• Volatility spikes
negative hedge fund returns and low volatility
sub-level returns.
16
Hedge Fund Performance 2004
• Are Hedge-Funds suffering only from increased assets allocated?
• Reversal of trends (FX, rates, metals), concomitant decline in equities and bonds,
historically low volatility
• Poor environment for hedge funds when:
 Both stocks and bonds decline (1994, 1998, Q2/3 2004)
 Fed liquidity tightens
 Commodity AND currency markets range-bound or choppy (2004 except oil)
 Low Equity market volatility
 Little opportunity for hedge funds
• Few investors have been invested in hedge funds long enough to have experienced
low hedge fund performance. Periods of negative performance are “normal” events.
Happens every 2-3 years: 1994, 1998, 2001, and 2002 all had performances at or
below 2004 levels.
• Q2/Q3 ’04 didn’t look so difficult for outsiders
attribution to AuM inflows.
• Volatility and volumes resumed after US elections
performance too.
17
FoF Performance vs Market Behavior 2004
Data Points
S&P 400
SSB US Govt Bond Index 10+
year, local currency terms
HFRI Fund of Funds
Composite Index
126 Months
Month Ended
Month Ended
Months Profitable
19
Down
Down
37%
47
Down
Unchanged
38%
28
Down
Up
39%
49
Unchanged
Up
61%
30
Up
Down
77%
49
Up
Up
86%
Source: Source Weston Capital
Management
18
Long-Short Global
2004 -To-Date
• 2005 commenced quite strongly: performances generated in Asia and EU
• 2004 performances fairly good; managers on our Approved List returning an average 7.5%
(end October)
• Most of performances generated in US some in UK
• Trend towards fundamental analysis & deep value approach reinforced
• Managers favoring concentrated positions
• Lessened impact of Macro Overlay; led to decoupling of returns vs intrinsic value of
positions
• Growing discrepancies between the performances of the EU / Asia and US markets.
Outlook 2005
• Markets increasingly attractive on fundamental/value perspective, particularly in Asia and
Europe
• Managers with real Asia/Japan experience expected to do well
• Monitor market reaction to lower USD
19
Long-Short Equity US
2004-To-Date
• Good results vs opportunities offered by equity markets. Most of the managers survived the
drop in January 05 , and made strong recoveries in February.
• Fundamental/deep value approach will continue to outperform.
• Concentration in portfolios
• Diversified portfolios have underperformed, tracking range-bound market movements
• Corporate events or special situations performed well; has attracted lot of assets and
arbitrage opportunities are being closed fast, leaving little time to perform detailed
fundamental research.
Outlook 2005
• Fundamental approach will prime
20
Long-Short Equity Europe
2004-To-Date
• European sector L/S Equity strategies’ average 04 returns were 5.96%
• As for US, European sector benefited from value plays vs growth stories. Strong cash flows
and annuities, visibility of recurring revenues, performed well & present in many funds
• Concentration, Themes (e.g. energy) and Sector focus outperformed
• Valuations cheaper than US; more liquid and less volatile markets.
• Knowledge edge and fundamental research outperformed
Outlook 2005
• Careful with macro events; ie USD weakness
• Will focus on managers with strong analytical capabilities and concentrated portfolios
21
Long/Short Japan
2004
A Cyclical Rally or the Beginning of Sustained Recovery ?
• In the 1st quarter, Japan was foreign investors’ market favourite, on the back of increased
signs of an economic recovery and easing deflation.
• Since May, Japanese markets have corrected around 14% from peak to trough: this was a
necessary adjustment to market frenzy of Q1.
• Most Japanese L/S managers were able to capture the Q1 rally. The most profitable themes
were “reflation” and consumption-related themes.
• Despite being hard-hit by the market correction, the average performance of our L/S
Japanese managers was good, with average returns of 9%. Best performers were
opportunistic managers, as they were able to quickly adjust their exposure according to
their top-down view.
Outlook 2005
• Micro picture is still positive: record cash flow after years of corporate restructuring,
management likely to be more friendly toward shareholders to guard against hostile
takeovers.
• Macro: BOJ forecasts nationwide CPI to grow 0.1% in fiscal year 05, signaling an end to
deflation.
• Major risks: Crude oil price, as Japan is a net importer (each $10 move in crude oil is said
to shave off 40bps off of Japanese GDP), strength of Yen which affects Japanese export
companies
• Will slowing export growth be offset by renewed domestic consumption?
22
Long/Short Asia
2004
A Turbulent Year
• Asian managers had a disappointing year compared to 2003, with an average performance of
9% compared to MSCI AP x Japan returning 19%.
• Most managers have been hit hard by market collapse in April and May, with China shares
losing 30% from their high in Jan’04.
• The sell off was substantially wider and affected all Asia Pacific markets
• Yet, corporate fundamentals were still strong : strong corporate earnings forecasts, solid cash
flow
• Therefore, the disconnect between good fundamentals and negative market sentiment hurt
Asian L/S managers, given that:
 They tend to have a net long bias and are therefore affected by market correction
 Cheap valuations did not justify raising short exposure
Outlook 2005
Short term cautious, long term bullish
• Significant risks: US & global slowdown, crude oil price, will foreign investors continue to
allocate capital to the region ?
• China’s buoyant economic growth does not necessarily translate into stock market gains :
wave of corporate scandals (China Aviation Oil), reminding investors that corporate
governance still not top of priority
• Over the long term, structural outlook for the region however remain impressive: strong
demographics, Asia’s share of global GDP growth now represent 27%
23
Technology
Mixed Results
The Nasdaq drifted during much of 2004, rallied in Q4 on a series of strong earnings reports;
Investors welcomed the Bush victory
TCS, inherently long-biased, performed extremely well thanks to great stock-picking on
both the long and the short sides
Level was the best-performing trading-oriented fund. Seeing no clear trends in the
technology sector, they continue to be nimble and operate with low net exposure and high
turnover.
Most opportunistic-driven managers were able to profit from the environment. Cantillon
made money on short semi-conductor positions.
2004-To-Date
•
•
•
•
•
Outlook 2005
• Long-term outlook for the TMT sector is very positive, based on supposition that PC and
Internet migration to wireless will drive the sector.
• We believe wireless communications will produce a watershed convergence of voice video and
data that will alter the technology landscape.
• However, in the medium-term the sector remains volatile.
24
Healthcare
2004-To-Date
• Healthcare industry severely hit due specific events; e.g. Chiron's failure to provide flu
vaccines and Merck's Vioxx withdrawal highlighted concerns about vulnerability to
lawsuits and increased regulatory scrutiny of drug safety.
Outlook 2005
• Even though the long-term outlook remains positive, given the needs of an aging
population, the currently low valuation and continued innovation, 2005 presents a very
difficult trading environment as regulatory issues persist.
• Recommend: caution.
25
Natural Resources
2004-To-Date
• Very strong performances from energy-related funds as oil prices rose sharply
• Strong performance from Natural Resources funds (RAB, Wessex) as markets remain
favourable for the strategy.
Outlook 2005
•
•
•
•
•
•
The Bull Case for Natural Resources
China‘s demand for raw material is high
World’s most populous country expands at annual rate of more than 9%
China is building 25 new nuclear plants: the price of Uranium will probably rise
Oil: Geopolitical risk: Insurgent attacks on Iraqi pipelines
Under investments in infrastructure and exploration over 10 years
Recommendation: favor long biased funds and managers active in exploration projects
26
Fixed Income
2004-To-Date
•
•
Historically low Credit spreads; tightening more pronounced for high yield than investment
grade spreads
Tight spreads sustained by:



•
A low credit default environment
Strong credit fundamentals
Strong demand for yield
Yield curve arbitrage had difficult year due lack of clear trends
Outlook 2005
•
•
•
•
•
Spreads to remain tight and range-bound near term, widening medium/long term
Catalysts may be earnings, lower demand as credit becomes expensive, oil price hikes and
geopolitical risks. Companies beginning to use their liquidity: increased M&A
Formation of yield curves trends have started; Flattening of the curve has been an early theme
(US & Europe)
2005 will be challenging for pure credit funds. Any Volatility pick-up and spread widening
would mean careful selection of funds
Recommendation: Funds diversified across fixed income strategies and able to implement
effective shorts in a credit pullback scenario
27
Merger Arbitrage/Event-Driven
2004-To-Date
•
•
•
•
•
•
•
Disappointing returns
Increase in announced deals
The spreads are unappealing as closely correlated to interest rates, plus market overarbitraged
In the US, the average IRR per deal is around 4-5% which is 3 to 4 times below 1999 and
2000 levels
The risk of a deal break and related cost is too high for reward
Spreads in Europe slightly higher since less capital allocated to strategy, rates slightly higher
and barriers of entries for arbitrageurs higher due complex and regulatory environment;
Outlook
2005
Favors
strong
experience
Prudent and not optimistic on Risk/Reward
Increasing pace of announced deals expected – spreads not expected to widen
28
Convertible Arbitrage
2004-To-Date
•
•
•
•
•
•
•
•
Performances ranging from -2% to +2%
Performances in line with market environment and strategies implemented by managers
Constant evolution of strategy and portfolios; today far more sophisticated vs 2000-2001
Volatility bias strongly penalized as realized volatility continues to drift lower than implied
volatility
Credit exposure or special situations posted performances above averages (e.g. Alexandra)
Continuing shift from managers toward a volatility-biased portfolio based on volatility
cheapness and credit spreads at historically tight levels
Little issuance and small issue size
Drift toward multi-strategy structure with event-driven and capital structure arbitrage(e.g.
Alexandra, K-Street)
Outlook 2005
• Focus on managers with original approach to convertible market, and those able to transform
infrastructure into multi-strategy platform with adequate resources
• Convertible funds with strong bias to volatility are cheap market hedge to equity markets due
historical low level of volatility
• Favour those managers with a strong fundamental bias.
29
Distressed Credit and High Yield
2004-To-Date
•
•
Strong year for credit as distressed and high yield managers average +10% - 15% for the
year as of November
Main driver is Institutional Investor behavior, not improvement in economic and business
fundamentals
Outlook 2005
•
•
•
•
•
•
•
Credit-picking is key component today
Spreads tightening and yields declining with higher implied risk (credit deterioration)
Could be sign of credit cycle reaching its peak; lending standards widen and low ratings
have tight spreads
Are Investors paid for the risk?
Credit cycles reach peak when optimistic projections of business fundamentals reach
unrealistic level that can’t be ignored, the derivative leverage suddenly becomes toxic
Seeking managers with cautious approach in current environment; Best opportunities on
long side after credit deterioration
Seeking niche player not involved in main-stream investments subject to swings of inflows
and outflows of mutual funds
30
CTAs and Macro in 2004
2004-To-Date
• Both strategies profit from directional moves on Fixed Income, Currency, Equity &
Commodity markets
• Macro managers seek fundamental factors for strong argument of directional move
• CTAs believe once trend has started it is likely to persist
• Macro: small positive returns; have kept exposure very low due lack of opportunities
• CTAs: lost on strong reversals in Fixed Income, Metals and Softs markets in April; to be seen
as profit give backs after successful 2003 (trend reversals)
• CTAs suffered following April from “false” breaks - primarily in currencies
• Energy markets profitable for CTAs (trend)
• Discretionary Macro traders performed well in Fixed Income markets
• Short term strategies generally performed well, but is a very small subset
• Q4 was very profitable for both Macro and CTA’s, as the weakening dollar move was
persistent and agreed on in terms of fundamentals
MOST IMPORTANTLY
• 2004 has seen most markets apart from Energy stay range bound. Currencies and equities
exhibited strong moves in Q4. These traders need directional, not sideways markets
31
CTAs and MACRO Outlook
Outlook 2004
• Following factors could cause repricings in Fixed Income, Currency, Equity and
Commodity markets:





Higher oil Prices
Growth in US trade deficit
Continued high level of Chinese Growth
Pick up in US Growth
Geopolitical Instability
• Markets rarely stay in tight trading ranges over a long period of time, economic and
political changes occur that force rebalances
• Directional strategies have least risk that inefficiency they profit from is eroded by too
many participants Markets move irrespective of CTAs and Macros due to much stronger
economic forces
CONCLUSION
• Directional Markets will return and these managers will once again profit
32
Asset Allocation Strategy
Strategy
Long Short Equity
Regions
CSFB Tremont Non
Estimated Industry
Recommended
InvestableWeight
Weights
Allocation Tilt
+
26.1%
Strategy
CSFB Tremont Non
Estimated Industry
Recommended
InvestableWeight
Weights
Allocation Tilt
Eq. Market Neutral
4.5%
Fixed Income Arb
8.2%
0
0
90.0%
5%
Global
0
US
50%
++
Directional
45%
Europe
20%
+
Non-Directional
50%
Asia
10%
+
Credit Arbitrage
Japan
15%
0
Event Driven
Sectors
10.0%
5%
21.6%
-
0
Event Driven Distressed
+
Bio & Health
20%
+
Event Driven Multi Strategy
Natural Ressources
25%
+
Even Driven Risk Arbitrage
Financials
10%
-
Managed Futures
Gold
10%
0
Short Term
10%
-
TMT
35%
+
Long Term
90%
+
-
0
+
5.7%
12.0%
-
0
+
Global Macro
Equity
40%
+
Fixed Income
0
Debt
60%
-
Diversified
+
Volatility
45%
+
Credit
10%
-
Multi Strategy
45%
0
Emerging Markets
Convertible Arb.
3.8%
0
5.0%
33
Thoughts and Trends on the HF Industry
Evolution
• From marginal and specialised industry to a professional, mature industry
• Focus has moved from “Quest for” absolute performance only to professionally structured
organisations and lower volatility – institutionalisation with performance as cost (however
risk/reward remains good)
• More focus on volatility than performance (Buffet: “I prefer a lumpy 15% over a smooth
12%)
• Expanded universe of strategies
• Absolute performance towards relative performance and capital preservation
• Consolidation: small structures struggle to survive
• Regulation is creeping in: Distraction from Trading will cost time and money

Not negative per se: Independent eye

Challenge to avoid conflicting regulations

Careful with complacency (20% of frauds were registered funds)

Structural risk
• Conclusion: Distinction between Alternative Investments and Traditional Investments is
disappearing. Hedge Funds – Active Management and Passive Management
34
Thoughts and Trends on the HF Industry
Leverage
• Post 1998 awareness limits excessive leverage at the hedge fund level
• Lack of opportunities also limit leverage
• Transfer of leverage to FoF level
 “Squeeze” more performance out of managers
 Low cost of money
• Leverage poses a threat at FoF level due to illiquidity
• Mitigated through strong portfolio diversification
• Additional leverage through structured products and enhanced liquidity through credit lines
35
Thoughts and Trends on the HF Industry
Supply/Demand Imbalance
• Access and capacity become major issues for FoF’s
• HF demand and high margins - new entrants often of lesser quality (low barriers to entry)
• New talent is not created at such speed and industry accommodates itself with lesser talent
• Need for strong research and due diligence to avoid pitfalls and remain with the best
• Bubble?
 Hedge Funds are a strategy, not an asset
 Symptoms of Bubble: Investors pay the same or more for less returns and ignore the
risk
 Complacency
• Mainstream Mutual Funds are adopting some money management techniques (Risk and
Exposure Management) as Hedge Funds, but … at a much lower cost.
36
Thoughts and Trends on the HF Industry
Increased Need for Structural Risk
• Reasons for failure per EDHEC study
 30% Fraud
 41% Misrepresentation
 14% Trading outside mandate
 6% Poor Process
• Structural risk analysis seek to reduce exposure to such risk through review of:
 Pricing policies
 Independence of NAV calculation
 Segregation of duties
 Infrastructure, controls and procedures
 Staff qualifications and experience
37
Final Quotes
“No, this is not the end. Not even the beginning of the end. But it is,
perhaps, the end of the beginning …”
Churchill
“You can’t get absolute returns without taking risk …”
William von Muffling
Which all results in a saner and tamer Hedge Fund World … but
with a few rebellious elements
J. Frogg
38