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Special Report

ESG: The metrics jigsaw


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Information is the life blood of investment, and nowhere is this more true than in hedge fund investment. As investors use funds more extensively and they become more accepted, investors need to become more aware as to how the different categories of the market operate and develop an understanding of their key characteristics.
The data below, supplied by Financial Risk Management, the international hedge fund specialist, tracks the performance of every type of hedge fund conceivable. The figures are FRM estimates of how the industry has grown in the past eight years and, more specifically, which of the four classes of hedge funds have flourished the most. The two bar charts are useful for comparison with one another (see figures 1 and 2). With returns some years running at 30%, it makes it more difficult to ascertain the relative size of the industry. Figure 2 shows the net flow of new funds allocated to each asset class.
But first some definitions. For the purposes of its research, FRM splits the diverse hedge fund strategies into four categories: directional trading, relative value, stock selection and specialist credit. As the name suggests, directional trading comprises strategies that speculate on the direction of the prices of currencies, commodities, equities and bonds in the futures and cash markets. Investment horizons vary considerably but managers are able to change their positions as a situation unfolds. Of an estimated $631bn (e716bn) market, this class of funds makes up $142bn, making it the second largest.
Under relative value come strategies that try to find and exploit spreads between the prices of financial assets or commodities. These strategies incur no intentional market risk although spread risk may be significant. Often statistical and mathematical techniques are used to identify and exploit opportunities, particularly where the hedging strategy requires frequent trading in order to maintain neutrality. Opportunities that the strategies try to exploit tend to be both low risk and low return so the managers will typically have significant leverage. This category accounts for $114bn in assets.
The third category, stock selection, is the most popular and most easily recognised type of hedge fund. Managers mix both long and short equity positions to varying degrees in an attempt to increase investment specific sources of return while reducing systematic risk. Key to this strategy is gauging which stocks are under and overvalued and buying and selling short accordingly until the market realises the mispricing and readjust. Market exposure within the various sub strategies varies considerably and so therefore do the risk and return profiles. Stock selection accounts for more than half of the hedge fund business or more than $345bn.
The fourth class, specialist credit, is on the fringes of the hedge fund world in that it provides credit in one form or another and as such is similar to private equity investment. Specialist credit strategies are based around lending to credit sensitive issuers, normally below investment grade.
The credit manager typically carries out intensive due diligence and purchases/sells those securities he feels are inexpensive/expensive. Returns come from capital appreciation, positive carry or both but the key to any specialist credit investment is the level of due diligence, the timing of the investments and the assumption of credit risk. Credit sensitivity may enable the manager to negotiate extremely favourable terms. This class is a niche with $30bn in assets.
Table 1 shows how the geometric returns, standard and downside deviation and largest drawdown vary across the strategies and how they measure up to similar data for the S&P 500 and the Lehman Aggregate. There are also Sharpe ratios for the various strategies. What this represents is the unit of return per unit of risk. The mathematical formula for standard deviation does not distinguish between positive and negative deviations about the mean. Downside deviation uses observations below Libor, so it is a good measure of its volatility of loss-making periods. The lower the number the less volatile the losses.
As the figures suggest, three of the four categories outperformed the S&P 500 between 1994 and 2001. However, volatility for the hedge fund strategies was significantly lower and their Sharpe ratios are considerably higher. As table 2 suggests, though, within each of the four types of hedge fund class, there are enormous differences between the various strategies making up each of the four headline classes. FRM breaks the data into the following constituents.
Directional trading strategies are split into discretionary trading, systematic trading and tactical allocation. Discretionary traders primarily use fundamental analysis to identify profitable trades. The timescale of these strategies is typically medium-term – supply and demand factors are often sought to anticipate corresponding price movements. Turnover tends to be high and positions are regularly assessed. For these strategies, average return between 1994 and 2001 has been 14.8%.
Systematic traders use rule-based models to identify trading opportunities, normally to be found in the futures and currency markets. These models identify trades as well as determining the size of the positions and the level of risk. Therefore the key difference between these strategies and discretionary traders is that under the latter, the fund manager has the final investment decision. Systematic trading is typically shorter term in its outlook and returns for this type of strategy averaged 14% since 1994.
The last directional class is tactical allocation, a top-down thematic approach that can invest in any process the manager deems appropriate. Often positions are sizeable and a significant slab of the portfolio may be pledged to a single theme. This approach is typically practised by the larger funds (often referred to as ‘global macro’ funds) and average returns between 1994 and 2001 stand at 9.7%. Taking large positions on single issues means returns can vary dramatically – in 1995 average returns were 33.3%. A year before they were –10.2%.
FRM breaks up relative value strategies into arbitrage, merger arbitrage and statistical arbitrage. Arbitrage strategies capitalise on price spreads between similar instruments. Returns are based on the theory of equilibrium, ie that the prices will ultimately converge and that by taking the correct positions, managers can add value. Arbitrage strategies typically focus on a specific asset class, varying from convertibles (known as convertible bond arbitrage), to mortgage- backed securities arbitrage where managers take positions in CMO derivatives trading with a high option adjusted spread. The average return for these strategies between 1994 and 2001 is around 12%.
Merger arbitrage exploits a discrepancy in the price of a security pre and post merger, takeover, restructuring or whatever transaction is taking place. For a straightforward merger, a typical strategy involves buying up equities in the target company and shorting those of the acquiring company. Although the strategy relies on the deal succeeding, in the past eight years the practice has returned an average 13.2%. Finally, statistical arbitrage looks for deviations in asset prices from what are deemed to be fair prices calculated by theoretical or quantitative models. Average returns from this have been around 12.4% in the past eight years.

In terms of the stock selection strategies, the most popular with hedge funds, the sub-categories long, short, variable and no-bias, refer to the composition of the portfolio. Long bias portfolios have a net long exposure to the underlying market. Typically for every $100 invested, a long biased manager will have $60–100 in long positions and $20–50 short. Short bias maintains a significant net short position while variable, although focused on individual stock selection, has no specific stance on the market. No bias strategies, known as market neutral, are the equivalent of the original Alfred Jones model and tend to balance long and shorts alike. As table 2 shows, long bias strategies produced an average 19% a year since 1994, short bias just 6% (unlimited liabilities on the short side can lead to significant losses).
Within specialist credit, FRM lists three categories, distressed securities, credit trading and private placements. Distressed securities involves investing in the securities of firms in or near bankruptcy and the returns are based on capital appreciation rather than on high yields. Credit trading strategies seek to take exposure to credit-sensitive securities long and/or short based upon credit analysis of issuers and security and credit market view.
Finally, private placements involve short and medium term investments in companies in need of rapidly available capital. Typically this involves investing in debt instruments with additional free options to buy the company’s stock at a low price. As the category is relatively niche the data is less complete than the other categories. Average returns for distressed investing over the period in question are 10.3%. Returns for private placements have proved volatile, but with annualised returns of around 21%.
Figures 1 and 2 demonstrate the growth in the overall hedge fund market. In absolute terms, the value of the total assets in the class has risen to $631bn at the end of 2001 from $161bn in 1994. The purpose of figure 2 is to show the funds that have been allocated to and withdrawn from each strategy. For although figure 1 is useful for illustrating the size of the market, returns of over 30% per year in some categories distort real and net growth.
As for figures 4 and 5, they are probably the most relevant for any pension fund or institution interested in investing in hedge funds. Figure 4 shows the annualised geometric return between 1994 and 2001, and the annualised standard deviation over the same period. The two lines and their corresponding points compare the risk return profiles of the four hedge fund strategies with a few more traditional indices. If the graph is to be taken at face value then the notion of investing in hedge funds appears absolutely failsafe. But this representation can be misleading and is no exception to the old adage of there being lies, damned lies and statistics.
Take the MSCI World index which, on average, has produced returns of 6.7% in the past eight years at an average standard deviation of 14.1%. The risk return profiles for the four hedge fund strategies are in the north west quadrant relative to the MSCI coordinate. In other words, they suggest higher returns for less volatility. Compare also the average return of directional trading and the S&P 500 on the basis of the graph, the two produce roughly the same average return but the volatility of the directional strategy is half the S&P 500.
The chart, often used to support hedge fund investing, is somewhat misleading as the points only refer to the average hedge fund manager. Nowhere in the graph is there any reference to the distribution of potential returns. No one doubts that if you pick a top performing hedge fund then the returns can be spectacular. Pick a dud though and the returns can be disastrous. Due to short positions and the leverage common to some of the strategies, it is possible to lose all the initial investment.
So what figure 5 demonstrates is the distribution of returns between the very best hedge fund managers and the very worst. Red dots in the middle of the characters represent the median manager for each category. The thicker purple boxes denotes the spread between the upper and lower quartile managers while the blue lines denote the top and bottom decile performers.

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