Edhec European Alternative Multimanagement Practices
Survey
Noël Amenc
PhD, Professor of Finance, Edhec Business School
Director of Research, Misys Asset Management Systems
noel.amenc@edhec.edu
December 5th 2003
Survey supported by:
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Agenda

Methodology

Facts, figures and trends in the European alternative
multimanagement market
Asset allocation and portfolio construction
Fund selection and due diligence
Risk and performance reporting
Regulatory framework

Conclusions and recommendations






Glossary
Typology of hedge fund styles
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Methodology
Scale of the initiative


A pan-European initiative
Two main questionnaires:
– General questionnaire for large asset managers
– Specific questionnaire targeting multimanagement structures


Survey conducted from 30/06/2002 to 31/12/2002
61 respondents managing €136bn at 31/07/2002
Distributionof
ofrespondents
respondentsby
bycategory
category
Distribution
Direct
Investors
18%
Distribution
Alternative Multimanagers
by number
Distribution
ofofalternative
multimanagers
by number
Other European
countries
7%
France
18%
United Kingdom
Advisors
14%
21%
Switzerland
Funds of
Hedge Funds
68%
34%
23%
26%
28%
0%
5%
10%
15%
20%
Number of Respondents
25%
33%
30%
European Universe
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
35%
40%
Methodology
Analysis of the size bias


44% of the sample is individually managing more than €1bn;
Bias not inconsistent with the fact that the 50 largest FoHF manage
90% of assets (Freeman & Co, 2003);
Distribution
of respondents
Distribution
of respondents
by size by size
AUM > €10bn
4%
€5bn < AUM < €10bn
4%
€1bn < AUM < €5bn
18%
€250mn < AUM < €1bn
18%
AUM < €250mn
17%
0%
5%
10%
15%
20%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Methodology
Importance of the background research


The survey has been designed and commented on with reference to
an analysis of the academic and professional state-of-the-art for
alternative multimanagement practices
This state-of-the-art has been documented in the background
section by the Edhec Risk and Asset Management Research Centre
based on the information collected in the context of its permanent
scientific and industrial observatory (more on www.edhec-risk.com).
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Facts, figures and trends
Main actors

A market structure similar to the US
– High Net Worth Individuals still represent the main category of investors;
– But institutional investors’ allocations growing at fast pace;
Fund of Hedge Funds investor composition (%)
Source: Goldman Sachs Prime Brokerage Annual Hedge Fund Survey, 2003
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Facts, figures and trends
Relativisation of alternative performance

The growing importance of institutional investors
– Investment approaches more related to diversification than absolute
performance;
– Need for normalisation of alternative investments (benchmarks,
reporting);
– Greater attention paid to operational risks.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Facts, figures and trends
From an alpha to a beta logic


63% of respondents offer FoHF by strategy;
Current motivations for investors, specifically institutional investors,
lie in the diversification benefits rather than in the selection of the
best managers, which is a preoccupation of Multimanagers;
Do you
offer
pure
strategy
manager
funds
Do you
offer
pure
strategy
manager
funds?
Yes
63%
No answer
4%
No, but we will soon
4%
No
29%
Why
(rank)
Why do
do Investors
investorsinvest
investininFoHF
FoHF?
(rank)
Advantages
Diversification
Risk Management
Capacity/Access to Funds
Due Diligence
Manager Selection
Consolidated Reporting
Investors
1
2
4
3
5
6
HFoF
Source: A Guide to Funds of Hedge Funds Management and Investments
AIMA, 2002
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
1
4
5
3
2
6
Facts, figures and trends
Relativisation of alternative performance

From an absolute performance to a relative returns approach
– The absence of exposure to market risk does not mean that hedge
funds do not carry any risk;
 The risk free rate is not an appropriate benchmark
 It is necessary to consider the risks strategies are exposed to in the
performance measurement approach
 Relative approach to performance measurement
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Facts, figures and trends
Relativisation of alternative performance

Alternative indices
– The need to demonstrate relative performance leads to the significant
growth of alternative indices.
– These indices are not only used for hedge fund performance analysis
but also as investment vehicles (trackers, structured products).
What indices do you use?
Country
Market indices
Proprietary indices
Composite indices based on market indices
Others
France
100%
25%
25%
25%
Country
HFR
CSFB
Zurich
MSCI Indexes (Standard, Value,
Growth)
S&P500
JPM
Switzerland
United Kingdom
45%
25%
9%
25%
36%
25%
27%
25%
France
50%
25%
25%
0%
25%
0%
Others
20%
7%
43%
11%
Switzerland
United Kingdom
20%
50%
40%
50%
20%
0%
0%
20%
0%
Total Europe
48%
17%
32%
22%
Total Europe
27%
27%
13%
50%
0%
50%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
20%
13%
13%
Facts, figures and trends
Relativisation of alternative performance

The utilisation of indices is not problem-free
– Indices are not passive, they are constructed like active manager funds;
– Indices suffer from numerous biases, mostly related to the absence of
regulation with regard to the publication of performance and hedge fund
composition;
– Selection and construction methods are the source of the performance
rather than the strategies.
Maximum returnMaximum
difference
by style
(From
January
through
July 2003)
Return Differences
by Investment
Style (From
January 19981998
through July
2003)
Investment Styles
Convertible Arbitrage
Max differences (with dates and indexes)
7.55% Dec 01
EACM (-6.93%) vs. Hennessee (0.62%)
CTA
5.09% Feb 99
Distressed Securities
6.99% Feb 00
EACM (1.23%) vs. Zürich (8.22%)
19.45% Aug 98
MAR (-26.65%) vs. Altvest (-7.20%)
Equity Market Neutral
5.00% Dec 99
Hennessee (0.20%) vs. Van hedge (5.20%)
Event Driven
5.06% Aug 98
Emerging Markets
Fixed Income Arbitrage
Funds of Hedge Funds
10.48% Oct 98
8.01% Dec 99
Global Macro
14.17% Oct 98
Long/Short Equity
22.04% Feb 00
Merger Arbitrage
2.71% Sept 01
Relative Value
10.47% Sept 98
Short Selling
21.13% Feb 00
CSFB (-0.54%) vs. HF Net (4.55%)
CSFB (-11.77%) vs. Altvest (-6.71%)
HF Net (-10.28%) vs. Van Hedge (0.20%)
MAR (2.41%) vs. Altvest (10.42%)
CSFB (-11.55%)
vs. Altvest (2.62%)
EACM (-1.56%) vs. Zürich (20.48%)
EACM (-4.32%) vs. HF Net (-1.61%)
EACM (-6.08%) vs. Van Hedge (4.40%)
Van Hedge (-24.30%) vs. EACM (-3.17%)
Source: Edhec Risk and Asset Management Research Centre
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Facts, figures and trends
Relativisation of alternative performance
In order to overcome these difficulties, Edhec has constructed a
series of indices of indices that exhibit higher levels of
representativity and purity
Representativity
Representativity
Purity
3,00
3,00
2,50
3,00
2,50
2,33
2,08
2,00
2,00
2,00
1,67
1,60
1,60
1,50
1,50
1,50
1,50
1,50
1,42
1,00
1,00
1,00
0,88
0,75
0,57
0,56
0,43
0,50
0,50
0,50
CSFB
EACM
CISDM
Van Hedge
HFR
Altvest
Zurich
Hennessee
Edhec
S&P
EACM
HF Net
0,00
0,00
Hennessee
CISDM
Van Hedge
Altvest
HFR
Zurich
CSFB
HF Net
0,00
0,00
S&P
0,63 0,63
Edhec

Source: Edhec Risk and Asset Management Research Centre, 2003
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Facts, figures and trends
Increasing attention to operational risks

The increasing importance of institutional investors and their desire
to protect themselves against operational risks is resulting in greater
attention being paid to these types of risks, which represent the
most significant source of hedge fund failures.
Analysis
Hedge Fund
Funds Failures
Analysis
ofofHedge
Failures
Multiple Risks
6%
Percentage of hedge funds potentially open to a specific
% of HF potentially
open to aissue
specific operational issue
operational
Compliance
63%
Pricing & NAV calculation
Operational
Risk only
50%
Investment Risk
Only
38%
58%
Client reporting
39%
Risk Management
27%
Reconciliation
Business Risk
Only
6%
Source: Capco research and Working
23%
0%
10%
20%
30%
40%
50%
60%
70%
Source: Edhec Risk and Asset
Management Research Centre, 2003
Paper “Understanding and Mitigating
Operational Risk in Hedge Funds”, 2002
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Asset allocation and portfolio construction
Specialization of offerings


Specialized fund offerings are provided more as an answer to
benchmarking needs rather than for their real diversification
benefits;
Only 42% of respondents offer funds exhibiting specific
diversification attributes with other asset classes;
you offer FoHF with specific behaviour or
DoDoyou
offer FoHF with specific behaviour or diversification
diversification objectives in relation to other asset
objectives
in relation to other asset classes?
classes?
Yes
42%
No answer
7%
Country
Yes
No
No, but we will
soon
No answer
No, but we
will soon
7%
France
40%
40%
10%
10%
Switzerland
United Kingdom
47%
40%
41%
50%
0%
12%
No
44%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
0%
10%
Asset allocation and portfolio construction
Specialization of offerings


Multimanagers’ lack of attention to the diversification properties of
hedge funds is probably linked to the confusion that exists between
the fund selection tasks, which constitute the original value-added of
the FoHF, and those relating to allocation or diversification by style.
While a significant majority of
European FoHF (75%) have a team
dedicated to portfolio construction
and/or return forecasts for alternative
styles, one cannot help but observe
that numerous European
multimanagers continue to confuse
portfolio allocation with the choice of
the best managers (22%).
Country
Members of staff
you
have
a team
dedicated
portfolio
DoDo
you
have
a team
dedicated
totoportfolio
construction
and/or
economicstyle
stylereturn
return
construction
and/or
economic
forecasting?
forecasting?
France
4
No
25%
Yes
75%
Switzerland
5
United Kingdom
8
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Europe
5
Asset allocation and portfolio construction
A necessary clarification of means and practices



Only 13% of respondents combine a quantitative approach with a
qualitative portfolio construction approach, even though it is the only
method that allows scenarios on extreme market conditions to be
taken into account while, at the same time, disciplining and
formalising the manager’s intuitions;
How do you construct your portfolio for
multi-strategy or multi-style funds?
65% of European multimanagers
do not use a quantitative approach
in the area of strategic portfolio
allocation, despite the results of
such approaches that have been
highlighted by academic research;
Only 47% of the professionals
questioned take the correlation
between funds into account to
organise the diversification of their
portfolio.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Asset allocation and portfolio construction
How much diversification is enough?

Academic studies have documented the fact that increasing the
number of funds may have adverse effects:
– Dilution of the specific betas of the different strategies employed;
– Alpha dilution and increase in additional costs (due diligence,
How
many
funds
on average
make up your
ownup
funds?
monitoring, etc.);
How
many
funds
on average
make
your
5% own FoHF?
13%
– Increase in the kurtosis of the funds;
5%
– Quantity can not replace adequate
22%
due diligence;
Fewer than 10

The numbers for practitioners
are significantly above the
optimal academic findings
(Amin and Kat, Lhabitant and
Learned), as only 18% of
respondents hold FoHF that
include fewer than 15 funds.
10 to 15
15 to 20
5%
20 to 25
33%
16%
25 to 30
More than 30
No answer
Country
France Switzerland United Kingdom Others Europe
0%
6%
20%
22%
Fewer than 10
13%
0%
6%
0%
11%
10 to 15
5%
30%
47%
50%
11%
15 to 20
33%
20%
6%
10%
28%
20 to 25
16%
10%
0%
10%
6%
25 to 30
5%
30%
29%
10%
17%
More than 30
22%
10%
6%
0%
6%
No answer
5%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
A match made in heaven?


While most alternative strategies exhibit abnormally distributed
returns, the vast majority of hedge fund selectors continue to use
tools from traditional management to evaluate their performance.
82% consider the Sharpe ratio and only 4% calculate an Omega
ratio, despite the fact that the latter is more appropriate for the
alternative universe.
Which quantitative
indicators
dodoyou
usewhen
when
monitoring
performance?
Which Quantitative
Indicators
you use
monitoring
manager manager
performance?
Total Europe
Sharpe Ratio
Sortino Ratio
M2 or SRAP Ratios
Drawdown Ratio
Return/VaR
Information Ratio
Return
Semi-deviation
Historique des ratios de Sharpe
Tracking error ex-ante
Correlation
Standard deviation
Beta
Alpha
Omega
B VaR
Skewness & Kurtosis
BULL/BEAR
Rolling 3 year annualised returns
Recovery Time
Very Important
35%
18%
2%
47%
24%
27%
5%
4%
4%
4%
4%
5%
4%
4%
2%
2%
2%
2%
0%
4%
Important
Not very important
47%
40%
13%
33%
35%
22%
0%
0%
0%
2%
4%
0%
2%
2%
2%
0%
0%
0%
2%
0%
11%
11%
27%
9%
15%
18%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Not considered
5%
25%
51%
5%
22%
29%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
Importance of the quality of hedge fund data


The performance databases play a central role for 67% of the
respondents, even though these databases contain numerous
biases and it is easily shown that the choice of database, and thus
the choice of particular biases, condition the performance of the
funds selected.
In spite of these problems, 44% of the respondents give quantitative
analysis a significant role in fund selection, even if, in the end, the
weighting accorded to the analysis does not exceed 37% on
average.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
Importance of the quality of hedge fund data

Only 15% of the respondents limit the use of quantitative analysis to
the first screening.
How important
do you
quantitative
whenselecting
selecting
managers?
How important
do consider
you consider
quantitativeanalysis
analysis when
managers?
Country
Not important, we only use qualitative analysis
It is used in the screening process to draw up a fund
list that is then subject to due diligence, but it is not
It is used in the screening process and is integrated
into the final evaluation, with a weighting of… %
We use qualitative judgement from the start of the
We use quantitative analysis to substantiate our
No answer
Country
Average
France Switzerland United Kingdom Others
0%
0%
0%
0%
Europe
0%
10%
12%
20%
17%
15%
50%
0%
30%
10%
41%
12%
29%
6%
20%
0%
60%
0%
56%
11%
17%
0%
44%
7%
31%
4%
France Switzerland United Kingdom Others Total Europe
30%
39%
38%
40%
37%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
The need for appropriate due diligence



In an unregulated environment, the FoHF capacity to limit
operational risks is essential and is now seen as clear value-added
for both investors and multimanagers.
This value-added is however questioned by the figures as FoHF are
not spared from the substantial and highly publicized hedge fund
failures. There is no significant difference in exposure between
FoHF and direct hedge fund investors.
If we examine the hierarchy of criteria, it is curious to note that the
quality of reporting and risk control of the underlying funds is
essential in the eyes of the managers who themselves do not
always have sufficient tools or skills of that type. As an example,
one-third of European FoHFs do not have a dedicated team for risk
analysis.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
The need for appropriate due diligence

It should be noted, in the same spirit, that, for want of a capacity to
genuinely reassure themselves on the transparency of the funds in
which they invest, European multimanagers rely more on the
reputation of their counterparty’s service providers (prime brokers,
custodians, auditors etc.) than on the operational analysis itself,
notably the off-balance sheet operations, which is not considered
important or indeed not taken into account at all by 27% of the
respondents.
Which qualitative
criteria
dodoyou
apply
todiligence
due diligence
a manager?
Which qualitative
criteria
you apply
to due
on managers?
Coherence and quality of explanations regarding the investment strategy
Quality of risk monitoring and reporting
Verification of fund performance
Legal soundness of the fund and the proposed contracts
Competence and credibility of key service providers (prime brokers,
custodians, auditors)
Analysis of the quality and liquidity of the instruments used by the fund
Organisation and reliability of the position evaluation process
Quality of technical infrastructure
Financial soundness of the manager
Quality of the decision support model or models
Managers' financial investment in the fund
Analysis of off balance sheet operations
"Market place" opinion on the fund
Quality of other subscribers
Transparency of the manager
Size
Reputational check
Consistency of investment process
Very Important Not very Important Not considered
96%
0%
0%
95%
2%
0%
91%
4%
0%
87%
7%
2%
85%
84%
84%
84%
82%
80%
71%
60%
47%
42%
4%
4%
4%
4%
13%
9%
11%
11%
11%
13%
9%
18%
29%
35%
0%
0%
0%
0%
Doyou
you
have
a specialized
risk
Do
have
a specialised
risk analysis
analysis
department?
department?
No
31%
2%
4%
2%
2%
4%
2%
9%
9%
20%
18%
0%
0%
0%
0%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Yes
69%
Fund selection and due diligence
The need for appropriate due diligence

More generally, we could set out the problem of the economics of
the profession of alternative multimanager. Projecting the costs of a
due diligence process cannot be sustained by FoHFs with assets
under management that amount to less than 200 million US dollars.
of operational
due-diligence
expressed
in
Cost Cost
of operational
due diligence
expressed
in basis
basis
of assets
management
pointspoints
of assets
underunder
management.
Fund Size
$50mn
$250mn
$600mn
$1,000mn
Cost of due diligence in bpts
160 bpts
32 bpts
13 bpts
8 bpts
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
The need for appropriate due diligence


This tight business model will lead to a clear consolidation and/or
outsourcing trend.
A pre-requisite for outsourcing however is that FoHF demonstrate
their ability to substitute for fund selection a clear new valueproposition: asset allocation and portfolio construction.
How do you select
How domanagers?
you select managers?
No answer
By sub-contracting due diligence
entirely
By partially sub-contracting due
diligence
Internally
0% 10% 20% 30% 40% 50% 60% 70% 80%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Fund selection and due diligence
The recurring question of transparency


76% of FoHFs do not set up “managed accounts,” regardless of the
amount of assets entrusted to the managers selected.
The associated costs and the fact that managed accounts have so
far not allowed extreme hedge fund losses to be avoided do not
favour this approach for FoHF. Managed accounts, however, have
the preference of large investment banking groups wishing to
implement structured products based on baskets of hedge funds.
Above which amount do you require segregation of your assets in a
Above which amount do you require segregation
managed account?
of
your assets in a managed account?
Country
No managed accounts
2mn
5mn
10mn
20mn
30mn
50mn
5%
2%
7%
76%
2%
5%
France
Switzerland
60%
88%
10%
0%
10%
0%
0%
0%
10%
6%
10%
0%
0%
6%
2%
No managed accounts
2mn
5mn
10mn
20mn
30mn
50mn
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Europe
76%
2%
5%
2%
7%
2%
5%
Risk and performance reporting
Multimanagers favour mean/variance reporting



The Sharpe ratio (69%) is well ahead of the VaR (20%) or the
Sortino ratio (22%) among the indicators that are favoured in the
performance reporting of European FoHF.
It should be stressed that volatility is considered by 84% of
Multimanagers to be the major concern of their clients.
However this concern does not result in information on the
diversification qualities of FoHF. FoHF are considered to be volatility
reducers not because they are exposed to interesting risk factors
within the framework of multi-style/multi-class diversification, but
simply because they exhibit low volatility themselves, even if this
entails a magnification of extreme risks that are neither measured
nor documented.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Risk and performance reporting
Multimanagers favour mean/variance reporting

Only 20% of respondents give information on the leverage effect of
the fund. This insufficiency could lead to erroneous performance
analysis, notably when a comparison with hedge fund indices is
carried out, which is the case for 62% of FoHFs.
Which
indicators
and information
do you use
for reporting
to your clients?
Which
indicators
and information
do you
use for reporting
to your clients?
No answer
M² or SRAP ratios
Comparison of fund performance with a benchmark made up of indices that
are representative of the strategy or styles in which the fund is invested
Style analysis
Conditional betas
Sortino Ratio
Measurement of the option characteristics of fund returns
Leverage effect measurement
VaR estimation
Volatility measurement
Sharpe Ratio
0%
10% 20% 30% 40% 50% 60% 70% 80% 90%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Risk and performance reporting
No place for third party certification


While studies on the failures of hedge funds have shown that
certification of their performance significantly reduces the failure
rate, it should be noted that only 13% of the respondents have
implemented certification by an independent third party.
The implementation of a FoHF performance standardisation and
certification process would be clear value-added for investors in a
universe where performances need to be analysed cautiously.
Is your reporting certified by an independent third party?
Is your
reporting certified by an independent third party?
Yes
13%
No
83%
No answ er
4%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Regulatory environment
Local rather than European initiatives


The UCITS III European Directive favours the development of
traditional multimanagement but does not allow for the development
of FoHF.
The regulatory competitiveness is a challenge not only for the asset
management industry but also for investors.
DoDo
your
haveananinfluence
influence
on choice
the choice
yourclients
clients have
on the
of legalof
legal
framework
for your
multimanagement
activity?
framework
available
for your
multimanagement activity?
No answ er
5%
Depends on the
amount of
business
27%
Yes
41%
No
27%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Regulatory environment
A long way to go for both parties
Which country offers the best compromise between
Which country offers the best com prom ise betw een flexibility and
flexibility
and security with regards to your alternative
security w ith regards to alternative investm ents regulations?
investment activity?
35%
30%
25%
20%
15%
10%
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
The
Netherlands
Italy
France
Cayman
Islands
Channel
Islands
Offshore
heavens
0%
Luxembourg
5%
Switzerland
A better level of information on
practices related to the management
of operational risks is a pre-requisite
for the development of HF and
FoHF marketing. The recent SEC
report is moving in this direction by
no longer ignoring HF and FoHF
and considering them as potentially
interesting vehicles for
diversification within mutual funds.
United
Kingdom

USA

A change in the regulator’s mind will most likely also require a
change in industry practices.
Selling alternative investments on the basis of indicators that do not
reflect extreme risks does not help.
Ireland

Conclusions and recommandations
1. The importance of portfolio construction


A major benefit of the Funds of Hedge Funds model resides in the
portfolio construction phase. Portfolio construction allows for
determining the optimal selection of hedge funds that compose the
portfolio in terms of risk and return profiles, but also for elaborating
the optimal mix of hedge funds that are required to complement a
portfolio invested in traditional asset classes.
Strategic and Tactical Asset Allocation approaches should therefore
be favored by funds of hedge funds managers rather than a bottomup, or fund-picking, approach aimed at selecting the future best
performers.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Conclusions and recommandations
2. Relativising absolute performance


The risk-free rate is probably not the adequate benchmark for
measuring hedge-fund risks as alternative investments exhibit
exposure to various non traditional risk factors (liquidity risk, volatility
risk, credit risk …).
Appropriate benchmarks need to be defined in order to assess the
real risks and returns of hedge funds and analyzing manager’s
alpha adequately.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Conclusions and recommandations
3. The need for appropriate reporting



Volatility is not representative of hedge fund risks, indicators
restricted to the mean-variance model should be supplemented by
more appropriate indicators.
Risk indicators should therefore account for the non-gaussian
aspects of risks hedge funds exhibit (skewness and kurtosis) as well
as for risk factors that are not captured by historical volatility (credit
risk,, liquidity risk …)
Appropriate indicators exist and are usually extensively used in
trading desks (Value at Risk,BVAR etc…)
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Conclusions and recommandations
4. Extreme risks are essential, but difficult to assess

Extreme risks form an important part of hedge fund risk. Two
categories of extreme risks need to be distinguished:
– Financial extreme risks (credit, liquidity …) that can fit into a quantitative
model
– Non financial risk that can only be assessed through an appropriate
qualitative analysis



Fund selection based exclusively on quantitative analysis does not
take into consideration the second category of extreme risks.
However, non Financial extreme risks represent an important part of
the risks hedge-funds exhibit.
Funds of Hedge Funds need therefore to balance quantitative fund
selection with an appropriate level of qualitative analysis.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Conclusions and recommandations
5. Qualitative analysis is challenging and expensive


Small and medium sized hedge funds encounter a difficult economic
dilemma when attempting to provide a minimum level of qualitative
investigations (lack of sufficient skills, resources and time);
The importance of these challenges will lead funds of hedge funds
to:
– Consolidate in order to minimize the relative cost of qualitative
investigation, or
– Evolve towards a model whereby focus is given to the portfolio
construction and qualitative assessment sub-contracted
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Glossary of terms
Risk and performance indicators
The Sharpe Ratio vs. the Sortino Ratio
These two risk-adjusted performance measures involve computing the excess return of an asset (over
the risk free rate for the former and over a predefined Minimum Acceptable Return for the latter) per
unit of risk. The major difference comes from the way the risk dimension is defined. In the Sharpe
Ratio the risk is defined as the total risk (i.e. volatility) of the asset while the downside risk (i.e. semi
deviation) is used in the Sortino Ratio.
The Information Ratio
This indicator is again a risk-adjusted performance measure which involves computing the excess
return of an asset over a benchmark per unit of risk. This time, however, only the relative risk (i.e.
tracking error against the benchmark) is taken into account.
The Drawdown Ratio
The drawdown ratio involves calculating the maximum peak-to-valley drawdown. It is thus an
interesting though simplistic way to assess extreme losses. This ratio is often associated with a
recovery time that is the number of days or months needed to recover losses.
The Beyond VaR (BVaR)
This measure calculates the expected shortfall provided that the VaR has been reached. This indicator
is based on Extreme Value Theory (EVT) and is thus well suited for assessing assets with fat tailed
return distribution functions.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Glossary of terms
Risk and performance indicators (continued)
The M2 or Risk Adjusted Performance (RAP)
This indicator is a classic risk-adjusted measure which involves calculating the excess return of an
asset over the risk free rate and then leveraging it by the volatility of the asset. The result is then
divided by the volatility of the market to obtain standardized values. This measure, however, does not
account for investment style differences.
Omega Ratio
This indicator is a typical gain/loss ratio. It is calculated as the ratio of the (probability weighted)
performance of an asset provided the predefined Minimum Acceptable Return has been reached by
the (probability weighted) performance of an asset in the case the predefined Minimum Acceptable
Return has not been reached.
Alpha and Beta
The return of an asset can roughly be divided into two parts. First, the "normal" return which
corresponds to the market's fair reward for the risks to which the portfolio is exposed. The betas
measure the exposure of the asset to each risk factor. Second, the “abnormal” return represents the
fruit of the portfolio managers' expertise. Technically speaking beta corresponds to the loading factors
of a regression of the asset’s returns onto risk factors, while alpha is the intercept of this regression.
Bull/Bear
This analysis aims to identify a potential non linear exposure to market risk. It involves comparing the
performance of an asset in down- and up- markets. Note that this analysis may give some indications
as regards the asset’s diversification properties.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Typology of hedge fund styles
Hedge Fund Universe
Relative Value
Event Driven
Opportunistic
Convertible Arbitrage
Distressed securities
Global Macro
Fixed Income Arbitrage
Deal/Merger Arbitrage
Long/Short Equity
Market neutral
Special Situations
Dedicated Short bias
Short Selling
Emerging markets
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Typology of hedge fund styles
Relative Value



Convertible Arbitrage: in its simplest form, this strategy involves the simultaneous
purchase of convertible securities (convertible bonds, preferred stock and various
equity-linked structured products) with the short sale of the underlying common stock.
By hedging the positions on a ‘delta neutral’ basis, the hedge fund manager can
capture income while neutralising most market risks.
Fixed Income Arbitrage: the hedge fund manager tries to capture differences in
performance between two or more portfolios of fixed income securities. The implicit
assumption is that the actual behaviour of such securities will be related over some
interval of time. However, beyond that simple (or simplistic) definition, there are many
fixed income arbitrage strategies that combine long and short positions. These
include yield curve strategies, spreads, swap spreads, basis trades, credit spreads,
option relationships and cross-market trades.
Market Neutral: by definition, a market neutral fund holds long and short positions in
equal dollar balance at all times, neutralising net exposure to equities. The manager
will simultaneously buy undervalued stocks and sell short overvalued stocks within
the same industry group or economic sector or the same investment style (growth,
value, small caps, large caps), keeping a beta-neutral exposure by sector or
investment style. In theory, an equity market neutral strategy’s return is not affected
by the direction of the market, on condition that the manager has been careful to
verify that the risk characteristics of his longs and shorts match.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Typology of hedge fund styles
Event Driven



Distressed Securities: distressed securities fund managers seek substantial capital
appreciation through investments in the securities of companies in, or about to enter
or exit, bankruptcy or financial distress. Distressed securities can cover a wide range
of possibilities, from senior secured debts (lower risk) to ordinary shares (higher risk).
Deal Arbitrage or Merger Arbitrage: merger arbitrage, also referred to as risk arbitrage
or deal arbitrage, is designed to ensure profits regardless of the direction of equity
markets. This strategy takes advantage of expected price movements, i.e. arbitrage
opportunities, which occur after a merger or acquisition offer. A classic scenario
consists of scooping up the stocks of the target company while selling the acquirer's
stocks short. Nevertheless, if the deal fails, this strategy can result in heavy losses.
Special Situations: though these strategies are very close to distressed securities or
deal arbitrage, special situations managers tend to focus on new investigative fields
such as debt in emerging markets, or bad news that depresses the price of stocks
sharply but temporarily. Leverage is not often used but the real nature of the
investment makes this strategy more volatile than the previous two.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Typology of hedge fund styles
Opportunistic



Global Macro: global macro funds were surely the most popular hedge funds 15
years ago. However, they are now in decline due to the disappearance of some
traditional sources of profit, such as arbitrage opportunities on Forex, which made
Soros’ fortune. These funds attempt to take advantage of macroeconomic trends and,
by definition, can intervene in any market. Through a top/down management process,
they implement multidirectional strategies (i.e. simultaneous exposure to several
markets).
Long/Short Equity: long/short equity strategies cover a broad range of risk and return
possibilities. As a result of this heterogeneity, the long/short equity category is the
largest segment in the alternative investment markets. Equity investing on a long and
short basis does not mean having a continuous market neutral approach as
described above, even though such a possibility may temporarily occur, especially in
the case of a bear market or when the manager no longer has a feel for the market.
Dedicated Short Bias: short-bias strategies involve managers taking short positions in
overvalued assets, by either selling borrowed securities or using derivatives to create
synthetic shorts. However these strategies can also take long positions over a limited
period of time while keeping their short bias.
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com
Typology of hedge fund styles
Opportunistic (continued)



Short Selling: the hedge fund manager takes short only positions in anticipation of a
decline in the stock value. At a later date, he will attempt to repurchase the same
shares at a lower price level to lock in his profit.
Emerging Markets: this strategy consists of taking long only positions, since short
sales are not allowed in emerging markets.
Managed Futures: this strategy consist of investing in futures and derivatives to
capture and amplify market movements
Edhec European Alternative Multimanagement Practices Survey - 2003 - © Edhec 2003 - www.edhec-risk.com