TW EU 2012 25068 Hedge Fund Investing Opportunities and Challenges

Hedge fund invsting
Opportunities and challenges

towerswatson.com
Contents
Hedge fund investing 01
Contents
Introduction Industry sees rapid evolution 02
Section one Industry trends 05
Managed accounts 06
Risk mitigation meets cost and complexity
UCITS hedge funds 12
Opportunity for all or accident in waiting?
Hedge fund fees 16
Towards a fairer deal
Section two Strategy review 20
Event-driven strategies 22
A decorrelated opportunity set
Managed futures/systematic strategies 26
Does quant macro work?
Active currency 28
A genuine hedge fund strategy?
Section three Hedge funds for less 30
Alternative beta 32
An introduction
Reinsurance 34
Strong stomach needed for proven strategy
Emerging market currency 36
Persuasive long-term fundamentals
Volatility 38
Clear premium: diversifying?
Summary Hedge fund research
Time and effort well spent 41
02 towerswatson.com
Introduction
Industry sees rapid evolution
Introduction
1 Sources: HFI, Barclays Capital, Preqin
2 Undertaking for Collective Investment in Transferable Securities
Since we began researching hedge fund strategies in the late
1990s, we have witnessed considerable changes in both the
industry and markets. Economic and nancial crises combined
with extreme volatility and difcult liquidity conditions have
challenged the way in which many investors construct their
portfolios. The market extremes have even caused some to
question the viability of a number of investment approaches.
Despite all this, we have seen robust interest
in, and increasing allocations to, hedge fund
strategies as investors continue to view them
as value-adding components of portfolios,
providing diversity as well as attractive risk-return
propositions. Assets under management in the
hedge fund industry hit US$2 trillion at the end
of 2011 and a recent survey expects this number
to increase to around US$2.6 trillion by the end
of 2012.
1
While this number is open to debate,
one thing is clear: hedge funds continue to attract
the interest of institutional investors and we see
a steady fow of assets into direct hedge fund
strategies. The fund of hedge funds (FoHF) model,
however, continues to experience headwinds.
Performance dispersion across hedge fund
strategies remains signifcant and whilst there
have been a number of successful new fund
launches competing against the established fund
managers, many others have failed amid tough
markets and sometimes over-infated expectations
of their ability to add value. The success of
any hedge fund portfolio clearly remains highly
dependent on the selection of skilled managers.
This publication aims to provide insights for
institutional investors with direct hedge fund
portfolios or those considering investing directly
in hedge funds. It offers practical analysis and
advice about how to structure investments as
well as about the investments themselves. The
issues we address include managed account
structures, the development of alternative UCITS
2

funds, shifts in the fee model and the growth
of cheaper alternatives to certain hedge fund
exposures. We critique some of the hedge fund
strategies that, during our discussions with
clients, have generated most debate.
We thank you for your participation in our
ongoing dialogue about these and other issues,
and hope you fnd the publication useful in your
deliberations over the place of hedge funds in
your organisations portfolio. We welcome your
feedback and comments.
04 towerswatson.com
01 Industry trends
Section one
Industry trends
As institutional demand for hedge funds has increased, it is
no surprise that we have seen considerable changes in the
requirements for product delivery. In this rst section, we
examine some of the current structural changes in the industry
and how they afect the ways in which investors choose to
invest. We argue that the structure and vehicle associated with
a hedge fund investment is as important as the investment
strategy itself. We focus on:
The pros and cons of managed accounts.
A popular structure since the fnancial crisis.
Managed accounts can offer control, ownership,
liquidity, transparency and customisation to a
portfolio, but there are challenges too: control
may not be as complete as hoped for; not
all hedge funds are willing to run managed
accounts and the costs tend to be high. We
feel that alternatives that lie in the middle
ground between direct investment and
managed accounts should be considered.
The growth of UCITS hedge funds.
These offer apparent transparency and
liquidity, which are sought-after commodities
post-Lehman/Madoff. However, before rushing
in, institutions should pause for thought: those
that have rounded out their due diligence teams
are already in a position to receive considerable
additional transparency over their investments.
Additionally, few longer-term investors actually
require daily liquidity. In addition, restrictions
on UCITS mean some of the best-performing
managers are not available outside the
traditional offshore hedge fund sector.
Fees. The balance of power is shifting away from
managers in favour of investors. Hedge fund
managers that provide genuine alpha can deserve
their fees and driving too hard a bargain with them
can be counter-productive, but investors should be
aware that their negotiating hand is now stronger
and that there are a number of possible fee
structures of which they can take advantage.
06 towerswatson.com
Why the increased interest?
While managed accounts have existed for
many years, the level of interest has increased
signifcantly since 2008. Interest in managed
accounts tends to be counter-cyclical to hedge
fund performance, waning when returns are strong
and gaining in periods of weakness. The problems
experienced by hedge fund investors in 2008 and
2009 including the gating of assets, question
marks over valuation approaches and exposure
to the Lehman and Madoff collapses led to a
sharp rise in appetite from investors looking to
access hedge fund strategies via a transparent
and liquid structure over which they have more
infuence and control. According to InvestHedge,
in 2011 there were nine dedicated managed
account platforms with US$25 billion in assets,
as well as at least 18 funds of hedge funds (FoHF)
either building platforms or investing through
separate accounts. In particular, fund of hedge
fund managers who lost signifcant assets in
2008 and 2009 see separate accounts as a way
to differentiate their product and as a channel for
raising additional assets.
Managed accounts explained
In managed accounts, an investment manager is
appointed as an independent advisor of the account
but, unlike pooled funds, the legal ownership of the
assets remains with the client or with a managed
account platform provider.
Managed accounts, also referred to as separate
accounts, can be set up by individual clients or
accessed through a managed account platform
provider, which reduces the administrative burden.
Depending on the platform and account type,
assets may be co-mingled with those of other
platform investors. The level of service offered by
managed account platforms, and consequently
the fees, can vary from being simply a conduit for
investing to a tailored fund of managed accounts
solution providing the same asset allocation
services as a typical fund of funds.
Managed accounts
Risk mitigation meets cost and complexity
01 Industry trends
Advantages of managed accounts
Proponents see the following benefts of investing
through managed accounts:
1. Better control and ownership of assets
In a managed account, the assets are
ultimately owned by the investor. In addition to
the increased liquidity and transparency this
provides (see below), the assets are held by
an independent custodian, meaning that the
existence and pricing of the assets can be
independently verifed. Following incidences of
hedge fund fraud in 2008-09, many investors
have sought increased protection. There are
other ways of achieving this, however, such as
using third-party risk aggregators. Similarly, the
majority of hedge funds now use independent
valuers for many unquoted assets and for
reviewing valuation policies. Our belief is that
reviewing the valuation policies of a fund should
be part of the due diligence process for any
client investing in hedge funds, especially
those that allocate to less liquid assets.
When investing through managed account
platforms, the assets are held in a separate
account by the platform provider. While
investors are protected against the manager
suffering issues, they remain vulnerable
to liquidity problems in the case of heavy
redemptions from the managed account
platform if assets are co-mingled.
Advocates of managed accounts also point
to the beneft of control. Pooled funds are
dependent on the directors of the fund acting in
their best interests. While boards are structured
with this aim, some have had cause to question
their independence. A managed account avoids
this issue as the investor has ultimate control
and thus the fnal say on decisions.
2. Increased liquidity
Given that investors retain ownership of the
assets in the managed account and are able to
replace the manager if they choose, managed
accounts provide ready potentially daily
liquidity. This increased liquidity is expected
by investors to provide a reliable exit route
in contrast to pooled funds, which can be
gated. However, regardless of the terms of
the account, speed of realisation is ultimately
determined by the liquidity of the underlying
assets. In times of market crisis, redeeming
managed account investors could receive their
assets in specie. Additionally, if the manager
is terminated, the liquidation and unwinding
of complicated or little-traded positions may
require detailed knowledge and experience.
3. Transparency enhancements
Separate account holders are often provided
with more transparency than investors in
pooled funds they may be able to receive
full portfolio holdings lists on a daily basis.
This extra transparency provides investors with
the ability to monitor risks on a real-time basis.
As such, they are able to identify and scrutinise
risk factors such as concentration, leverage,
liquidity, exposures and style drift on a very
regular basis.
The value of transparency is largely dependent
on what the investor does with the information.
While there may be potential to add value
through dynamic asset allocation, this requires
the investor to have greater skill in timing the exit
and entry of opportunities than the underlying
managers. Furthermore, in order to exploit the
advantages of additional transparency, investors
need a risk system capable of absorbing
daily holdings information and modelling their
positions. Managed account platforms typically
provide such risk measurement and aggregation
systems services as they are needed. Given that
institutional investors typically have a long-term
horizon and are not looking to tactically trade
their hedge fund portfolio exposures, few have
the need for daily transparency.
4. Protection in the event of redemption pressures
If managed account investor assets are not
co-mingled with those of other investors, they will
not suffer through the realisation of the bid-offer
spread as in a pooled fund. However, typically,
there is signifcant overlap between managed
account assets and those of pooled funds. In
more extreme events, heavy redemption requests
from the pooled fund will result in the forced sale
of assets and managed account investors are
likely to see a downward price impact.
5. Greater customisation possible
The managed account structure allows
investors and platform providers to customise
their investment and stipulate investment
restrictions for example restricting position
sizes and maximum leverage limits. Such limits
can signifcantly reduce the potential impact
of negative events on the strategy and limit
style drift. However, having a specifc set of
restrictions applied across all strategies can
signifcantly limit a managers scope to generate
returns. Also, while leverage and concentration
can increase left-tail risks, they can also be
useful tools for alpha generation in the hands
of skilled managers. So restrictions are a major
source of tracking error for managed accounts.
08 towerswatson.com
In addition, investors looking to avoid highly
levered or highly concentrated strategies could
achieve this alternatively through the selection
and monitoring of their hedge fund managers.
6. More attractive fees
The managed account structure provides
managers with a way to circumvent
Most Favoured Nation clauses which apply to
pooled funds, so there may be scope to negotiate
more attractive fees from the investment
manager. However, this is traded off against the
additional costs to the manager and investor
of the managed account structure. Managed
account platforms tend to be expensive, typically
charging fees in line with those of a fund of
hedge funds provider. Improved fee structures
can equally be achieved by creating a separate
share class within a pooled fund structure.
Disadvantages of managed accounts
1. Adverse selection bias
Historically, managed accounts were viewed
as structures provided only by second-class
managers who struggled to raise assets through
other vehicles. While the events of 2008 and
2009 have meant a greater number of managers
are willing to provide managed accounts,
particularly those who lost assets through 2008
and 2009, there are still a large number of
hedge funds that remain strongly against these
structures, resulting in an adverse selection bias.
In other words, investors will not be able to gain
access to some of the best funds.
In addition, the ability to provide managed
accounts varies by strategy. Some strategies will
simply not be available. For example, it is usually
straightforward for Commodity Trading Advisor
(CTA) managers, who invest primarily in highly
liquid forward and futures contracts, to provide
separate accounts. However, other strategies are
less suitable, including debt or equity strategies
which invest in private transactions, strategies
focused on less liquid assets and those that look
to exert control over companies. This is because
of the diffculty in valuing these positions, the
inability to split allocations across different
accounts and the required minimum deal sizes.
Many managers choose not to run separate
accounts because of the administrative
burden. Managed accounts create additional
costs and complexity for managers, including
initial set-up costs, the cost of implementing
positions across numerous accounts, adhering
to tailored guidelines and monitoring numerous
accounts. As a result, some managers may
require a signifcant minimum investment (up
to US$100 million when setting up a managed
account). Additionally, some managers do not
like managed accounts as they make it more
challenging to create equality of terms and
transparency across clients. Some managers
also perceive that providing transparency
results in confdential information being
released which could degrade their ability to
pursue the strategy successfully in the future.
As a result of the number of managers
unwilling to offer managed accounts it may
not be possible to access the same line-up of
quality hedge funds through managed accounts
as it is through pooled fund investments. Of
our current highest-rated hedge fund managers,
only a handful offer the ability to invest via
managed accounts.
2. Increased liability
The increased transparency, customisation
and control provided through managed accounts
may mean a transfer of liability to investors, given
that they are in a better position to monitor and
control risks.
3. Reduced alignment of interests
Portfolio managers typically co-invest in pooled
funds, which should improve the alignment of
interest between manager and client. However,
managers are unable to co-invest in managed
accounts and, given tailored guidelines and
varying liquidity, this can result in a reduction in
the alignment of interests. In the extreme case
of the liquidation of a fund, it is usually better to
be invested in the same vehicle as the manager.
4. Additional costs and
administrative requirements
Following due diligence and selection of a
manager, the set up of a managed account
requires several additional steps, which are
detailed in Figure 01. In particular, setting
up arrangements with various counterparties
and service providers is likely to be onerous.
Unlike investing in pooled funds, clients (or their
advisors and representatives) are required to
negotiate their own terms (and International
Swap and Derivatives Association agreements,
or ISDAs) with service providers including prime
brokers, fund administrators, cash custodians,
security custodians, and over-the-counter (OTC)
counterparties. Investors are unlikely to negotiate
terms as favourable as the hedge fund manager
has in place because the manager typically
has greater leverage in negotiations, given their
higher asset levels and trading volumes versus
the client. However, costs can be reduced
signifcantly for large-scale managed accounts.
Managed account platforms can provide some
of these services but platform fees can be high
and are in addition to fees paid to the underlying
hedge funds.
01 Industry trends
The managed account alternative:
Funds of One
Given the costs and challenges associated with
managed account investments, some clients and
managers have looked to use a Fund of One as
middle ground between pooled fund investments
and fully separate accounts. A Fund of One can
take several forms:
A separate offshore vehicle created for one
particular client.
A separate feeder fund of an existing master
feeder vehicle.
A separate share class of an existing fund
created for a single client.
The key difference between a Fund of One and
a managed account is that the manager retains
ownership and control of the assets, is responsible
for the custody of the assets and retains all the
counterparty relationships. The extent to which
a Fund of One avoids the co-mingling of assets
with other investors depends on its structure if a
separate offshore vehicle is created, there will be
no co-mingling. However, in the case of a separate
feeder fund or share class, assets will still be mixed.
Similarly, to create tailored guidelines or customise
the strategy will require a fully separate vehicle.
Given that a Fund of One does not give away
as much control as a managed account, and
does not demand the same levels of additional
administration, some managers who will not
offer separate accounts may offer a Fund of One.
Note that the cost of setting up and the ongoing
administrative costs of these options will be borne
by the client.
Source: White paper Separate accounts as a source of hedge fund alpha
by Deepak Gurnani of Allstate and Christopher Vogt of Northbrook
Figure 01. Separate account requirements
Suitability
Legal
Guidelines
Service Providers
Counterparties
Financing
The graphic shows the main considerations and steps in setting up a
separate account with a hedge fund manager.
10 towerswatson.com
A solution for some, not for all
While managed accounts offer many potential
advantages to investors, including control of assets,
transparency and liquidity, we believe the costs of
these structures and the governance requirements
of operating them outweigh the benefts for many
investors. The majority of institutional investors
have naturally long-term investment horizons and
do not require daily liquidity or daily transparency
from their investments. We continue to focus on
identifying managers who are suffciently skilled
in a breadth of strategies so that clients are not
required to time their entry and exit. In most
cases, we do not believe that having an account
with daily liquidity will provide investors with
an advantage few are equipped to deal with
payments in kind from redemptions, for instance.
We believe investors should continue to focus
on ensuring that the terms of the investment
vehicles they choose are well-aligned with the
investment horizon of the underlying assets and
that they are investing in funds where there is a
strong alignment of interests with the investment
manager. Nevertheless, the desire for investors
to have more control over their assets and to
have more of a say in the valuation process is
causing many to examine the alternatives to
pooled funds. While a number of the benefts
of managed accounts or Funds of One can be
achieved by negotiation when investing in a
pooled product, some needs are only met
through non-pooled solutions.
01 Industry trends
Differences vs offshore
pooled funds
Managed accounts
Managed account
platforms
Fund of One
Different liquidity terms Yes Yes
? Depends on
individual negotiations
Ability to exit in
crisis environment
? Likely to receive assets
in specie and ability to
exit will depend on clients
ability to fnd suitably
skilled replacement advisor
? Likely to receive assets
in specie and ability to exit
will depend on clients or
platform providers ability
to fnd suitably skilled
replacement advisor
? Depends on
Control and ownership
of assets
Yes
? Control and ownership
may sit with either the
platform or the client
depending on the structure
No
Different fee terms
? Depends on
? Depends on
? Depends on
Reliant on Fund Board
acting in best interests
of fund shareholders
No No
? Depends on
Protection from the impact
of other clients redeeming
? Protection from
realisation of short-term bid
offer spreads. However, given
overlap in portfolios, large
scale redemptions are still
likely to affect asset pricing,
particularly in the case of
less liquid assets
? Depends on the
structure of the platform,
may be impacted by fows
from other investors in the
platform and also subject
to the same concerns as
managed accounts during
large scale redemptions
No in the case of separate
share class/feeder structures

? If structured as a
completely separate vehicle
day-to-day protection but
exposed to the impact of
large scale redemptions
as with managed accounts
given the overlap in holdings
Increased transparency Yes Yes
? Depends on
Customisation of strategy Yes Yes
Only available in a
completely separate
vehicle
Increased administrative
costs
Yes Yes
Yes albeit less than
in a managed account
Adverse selection bias Yes Yes
Yes albeit possibly less
than for managed accounts
Requirement to negotiate
own ISDAs
Yes Done by platform provider No
Figure 02. Summary of options
12 towerswatson.com
UCITS hedge funds
Opportunity for all or accident in waiting?
UCITS hedge funds divide investment managers:
some view them as an accident waiting to happen
while others see them as a golden opportunity to
attract assets from investors who abandoned the
industry following the fnancial crisis of 2008 and
to rebuild a more diversifed client base. From the
investor viewpoint, the liquidity advantages have
to be set against the restrictions on shorting and
leverage, which can act as a drag on return potential.
UCITS explained
The UCITS
1
regulations are a set of European Union
(EU) directives that allow open-ended EU-domiciled
funds investing in transferable securities to be
subject to the same regulation in every member
state. The intention is to reassure investors that
funds which have obtained UCITS approval have
met certain thresholds with regards to transparency,
liquidity, diversifcation and risk control.
UCITS funds have traditionally followed simple
long-only strategies and these still represent the
bulk of UCITS assets. But the UCITS directive
also allows hedge fund-like strategies to be
implemented within its framework, provided
specifc risk limits are met. These are known
as Alternative UCITS or UCITS hedge funds.
Growth of UCITS hedge funds
UCITS funds have enjoyed spectacular growth
over recent years, particularly in the wake of
2008. The UCITS market as a whole represents
approximately 73% of investment assets in Europe,
or 5.6 trillion.
2
(As a point of reference, the entire
US mutual fund industry is 9.2 trillion.)
The number of Alternative UCITS funds now
exceeds 1,000, with around two-thirds of these
having been launched since the fnancial crisis.
This illustrates how transparency and greater
regulation have acted as a real catalyst for growth,
particularly among European and Asian investors.
Total assets under management (AUM) for
Alternative UCITS stands at approximately
US$115 billion.
A number of events have contributed to
this growth:
Diffculties experienced by hedge fund investors
following the fnancial crisis, including the gating
of assets and exposure to both Lehman and
Madoff, have created increased appetite to
access hedge fund strategies via transparent
and liquid structures.
1 Undertaking for Collective Investment in Transferable Securities.
2 Source: European Fund and Asset Management Association,
August 2011
01 Industry trends
Institutional investors increasingly wish to
move away from benchmarked products
and invest in more fexible hedge fund-like
mandates. At the same time, offshore hedge
fund managers have looked to tap the deep
pool of pension fund assets.
Some investors have fought shy of offshore
hedge funds given increasing regulation over
recent years.
UCITS is a recognised brand across the globe
and funds can be marketed to a very broad
geographical and segmented investor base.
The demand for UCITS products from traditional
hedge fund investors is partly a reaction to
the fnancial crisis. European investors were
responsible for a large percentage of the
US$300 billion of global outfows from the
industry in 2008 and 2009. Investors who have
returned have tended to prefer Alternative UCITS
to traditional hedge funds. Daily or weekly liquidity,
a regulatory rubber stamp, lower perceived risk
(owing to limitations on leverage and concentration
levels) and increased transparency are all
characteristics valued by private investors, FoHFs
and family offces in particular.
Retail investors, mainly accessed via distributors
such as fund platforms, IFAs, retail banks and
defned contribution pension providers also
represent a large share of the Alternative UCITS
asset base, and are likely to be the biggest source
of growth in the future.
To date, institutional investors have, by and large,
not chosen Alternative UCITS over traditional
hedge funds, for the following reasons:
Institutions tend to be long-term investors, with
little need for daily/weekly liquidity; many would
rather capture the illiquidity premium associated
with longer lock-ups.
The constraints imposed by a UCITS structure
on concentration and leverage represent a drag
on performance.
Hedge funds have themselves improved
transparency and governance post 2008.
Institutions have boosted their internal due
diligence teams so are better placed to select
traditional hedge funds.
There are not a large number of Alternative
UCITS funds with a suffciently long track record.
UCITS funds tend to be too small to
accommodate large institutional infows.
Legal constraints that prevent certain
institutions from investing in UCITS.
14 towerswatson.com
Alternative UCITS are currently concentrated
in the following strategies:
Equity long-short (27%): this is a refection of
the ease with which equity long-short strategies
can be packaged into UCITS products. The
majority tend to be Europe-focused strategies.
Fixed Income (18%): these tend to differ from
their traditional hedge fund counterparts by
being absolute return rather than relative
value funds.
Mixed arbitrage and multi-strategy (15%).
Volatility trading (10%).
Credit including convertibles and emerging
markets (9%).
Macro (7%).
Equity market neutral and quantitative
strategies (6%).
Event-driven (3%).
Managed futures (3%).
1
UCITS suitability depends on the
underlying strategy
The decision whether to shift to a UCITS structure
depends to a large extent on the underlying
strategy. We consider below the broad categories
of hedge fund investment strategies and their
suitability for UCITS. The greatest challenges tend
to be found in credit and event-driven funds, as
well as macro and arbitrage funds.
Equity long-short
Equity long-short is the strategy which has
dominated hedge fund UCITS launches to date
and is most easily structured as UCITS given
that most equity long-short managers hold
highly liquid assets.
The main constraint for equity strategies is the
requirement for short exposures to be expressed
entirely through derivatives. The potential
increased cost of implementing short positions
through derivative instruments will impact returns.
A number of sub-strategies within equity
long-short struggle to ft into a UCITS wrapper.
These include:
Strategies that focus on less liquid equities
such as small cap or unlisted equities.
Some concentrated strategies particularly
those that use leverage fall foul of the
diversifcation requirements. A 5% position
in a four-times levered fund, for instance,
would breach the 20% concentration limit.
Some levered strategies may be constrained by
the 300% maximum gross exposure limitation.
Credit long-short
The key challenge for credit long-short strategies
is to maintain liquidity and to deal with the
prohibition on exposure to loans. Funds that
focus on lower credit quality issues and event
investments will struggle to offer the liquidity
required by UCITS. The exception to this may
be credit trading funds, which make signifcant
use of credit default swaps (CDS). The limits on
concentration may also be an issue, particularly
where leverage is applied.
Macro and managed futures
For traditional long-term macro strategies and
managed futures managers, who primarily trade
directional views using liquid futures, restructuring
in a UCITS wrapper should present few problems.
However, more complex strategies have tended
to bear little resemblance to the offshore funds
they are based on. The liquidity constraints and
requirements to reduce complexity are onerous
for these strategies and the number of line items
must be reduced. Similarly, high frequency trading
does not ft well with the UCITS approach. Due to
liquidity constraints, relative value spread trades
may also be removed from the opportunity set.
The limitations on cash shorts and investment
in commodities also have implications for
these funds. While some of these opportunities
might still be accessed indirectly through
derivatives, this leads to increased cost and
reduced opportunity. Requirements relating to
collateralisation of derivative contracts adds
to costs and reduces the opportunity set.
The concentration limits pose further issues,
especially when leverage is applied. In particular,
the limit of a maximum 100% net exposure to
US Treasuries may limit these strategies.
Fixed income relative value and arbitrage
These strategies are likely to be required to
reduce leverage to meet VaR and concentration
constraints and may have to execute less
proftable arbitrage strategies. The constraints on
shorting cash bonds may also have an impact
for example, on funds looking to exploit anomalies
between on-the-run and off-the-run Treasury bonds.
While many of these strategies can be replicated
through derivatives, this entails higher costs. We
would have concerns regarding arbitrage strategies
offering generous liquidity terms since liquidations
in adverse conditions can come at signifcant cost.
1 Source: Barclays Capital Prime Services, Hedge Fund Pulse,
November 2011.
01 Industry trends
Event-driven
This includes distressed debt, merger arbitrage,
activist and event-driven multi-strategy funds.
These are probably the most diffcult to restructure
as UCITS funds. In fact, many of these strategies
should in theory be precluded from UCITS given
their typical long investment horizon and illiquid
nature. Furthermore, these funds can be relatively
concentrated activist investments can require a
large holding in one name. While merger arbitrage
strategies may be more liquid than some of the
credit focused event-driven strategies, securities
used in merger arbitrage may also become illiquid
at times and give rise to a mismatch with the
redemption period.
Funds of Hedge Funds
UCITS restricts investment in other funds. It requires
the target funds to be supervised in much the same
way as UCITS and restricts cumulative investments
in non-UCITS funds to 30% of net asset value. These
restrictions signifcantly reduce the investment
universe available to funds of hedge funds, both
in terms of the number of available funds and the
strategies that can be accessed. So the potential
for funds of hedge funds to add value through
asset allocation is reduced.
Liquidity and transparency come
at a cost
Interest in UCITS, and Alternative UCITS in
particular, has grown signifcantly following the
fnancial crisis and it seems likely that these
vehicles will continue to gain traction among
investors that value liquidity and transparency.
While there have been a number of hedge fund
launches in the UCITS space, it is not clear
that the UCITS structure suits many hedge fund
strategies. We would expect the returns and
volatility of UCITS funds to be less attractive than
those of offshore vehicles, principally due to their
inability to exploit the illiquidity premium and the
reduction in the opportunity set.
Strategies that are liquid and diversifed may be
relatively easily repackaged for UCITS investors,
but other strategies are more challenged. In
particular, we note that credit, event-driven
and more complex macro strategies along with
funds of hedge funds have to undergo signifcant
amendments to their strategies in order to become
suitable for UCITS investors.
The primary investors in UCITS vehicles continue
to be retail investors, but the suitability of these
vehicles for institutional investors is open to debate.
For the latter, which have a longer-term investment
horizon, the onerous liquidity requirements imposed
on UCITS hedge funds may be unnecessary and the
resulting performance drag of providing liquidity to
shorter-term investors may be too high.
16 towerswatson.com
Hedge fund fees
Towards a fairer deal
A changing dynamic
For a number of years, supply and demand
dynamics worked in favour of hedge fund
managers. Limited capacity led to rising hedge
fund fees and structures evolved with provisions
that skewed the alignment of interests between
investors and managers. Fee and fund term
negotiations were limited and many managers hid
behind Most Favoured Nation clauses which were
originally designed to protect investors, but which
became an excuse not to offer concessions.
The events of 2008 and the subsequent pressures
faced by many hedge funds led to a re-evaluation
of the value added by hedge funds and the way
that this is shared with investors. The terms
offered by many managers, as well as the
traditional 2+20 fee model came under scrutiny.
Investors providing sizeable allocations and with
a long-term investment horizon found themselves
in a position of considerable negotiating power.
We believe skilled managers should be rewarded
for alpha. We do not believe that cheaper is better,
but we do think that the combination of the hedge
funds fee and portfolio exposures (gross, net and
beta) should be structured to allow for a more
reasonable alpha split between the manager and
end investor. Given that investors place 100%
of their capital at risk, we view a two-thirds to
one-third split of alpha between investors and
managers respectively as an ideal division.
Here, we examine the structure of hedge fund fees
and terms and how these have evolved since the
fnancial crisis. We believe that both are equally
important in achieving a structure that better
aligns the interests of funds with investors.
A. Types of hedge fund fee structure
Hedge fund fees usually consist of:
An annual management fee, and
A performance or incentive fee.
We believe structures that are well-aligned
should include:
Management fees that properly refect the
position of the business.
Appropriate hurdle rates.
Non-resetting high watermarks
(known as a loss carry-forward provision).
Extension of the performance fee
calculation period.
Clawback provisions.
Reasonable pass through expenses.
Hedge fund managers should be compensated
for their skill (alpha) and not for delivering
market returns (beta). The separation of alpha
and beta is complex, but in our view worth
analysing in detail. In the context of constructing
appropriate fee structures for hedge fund managers,
we base our estimates on assumptions of
expected alpha generation per 100% of gross
exposure. This is married with the forward-looking
estimate of gross and net exposures of the fund
to calculate a gross alpha expectation. Total fees
payable are then assessed as a proportion of
total gross alpha. We have a target level of about
30-40% of this alpha being paid to the manager.
01 Industry trends
Annual management fees
The management fee often set at 2% of assets
provides the manager with revenue to cover the
operating costs of the frm. In some large funds,
the management fees may form a signifcant
part of the managers proft. We would prefer to
see annual management fees aligned with the
operating costs of the frm, leaving the performance
fee for employee bonuses. Over the course of
2009, our managers reduced the management
fee to an average of 1.5%. We would ideally prefer
to see tiered management fee structures (on a
sliding scale) given that a frms operating costs
do not normally increase in line with assets under
management. We do, however, recognise that
there are some strategies where alpha generation
is reliant on growth in research resources or
signifcant ongoing technology investments.
Performance, or incentive, fees
Performance fees are usually calculated
as a percentage of the funds profts net of
management fees. The performance fee is
generally used to pay staff bonuses and equity
holders. Typically, hedge funds charge 20% of
returns as a performance fee, payable annually.
We believe historical performance fee structures
do not suffciently align manager and investor
interests; managers share profts, but there is
often no mechanism for them to share losses so
there is an incentive to take excessive risk rather
than targeting high long-term returns. Structures
that contain hurdles, high watermarks and those
that defer fees with the ability to claw back in the
event of subsequent drawdowns are preferable.
Where an investment vehicle is set up to liquidate
a portfolio, we would prefer to see no performance
fees charged.
Hurdle rates
The use of a hurdle rate signifes that a manager
will not charge a performance fee until performance
exceeds a pre-determined target. Using a hurdle
encourages a hedge fund manager to provide a
higher return than a traditional usually lower
risk investment.
A manager may employ a soft hurdle where
fees are charged on all returns if the hurdle rate
is cleared. Others use a hard hurdle, where fees
are only payable on returns above the hurdle rate.
We prefer fee structures that include appropriate
hurdle rates. These should refect the level of
net market exposure of the fund, although in
practical terms sometimes this is diffcult to
implement. A hurdle based on a risk-free rate
can be more workable.
High watermarks
A high watermark can be applied to the calculation
of the performance fees to limit the fees payable.
It prevents a manager from taking a performance
fee on the same level of gains more than once,
and means that a manager will only receive
performance fees when an investment is worth
more than its previous highest value. Should the
value of an investment decline, the fund must
bring it back above the previous highest value
before it can charge further performance fees.
Some managers make use of modifed high
watermarks such as an amortising high watermark,
which spreads any losses over the longer term,
enabling the manager to earn at least some of
the performance fees in the current period. With a
resetting high watermark, any losses are erased
after a defned period of time has elapsed meaning
managers can charge fees again before reaching
previous peak value.
We prefer the use of traditional non-resetting
high watermarks to ensure performance fees
are not paid on the same investment gains
more than once. However, we acknowledge
that a period of earning no performance fees
can put tremendous pressure on a managers
business. This could lead to diffculties retaining
talented investment professionals, and create
an incentive to close the fund and simply start
another one. A well-structured, modifed high
watermark provides managers with the resources
to reward their best-performing staff and enable
them to stay in business. An example of this type
of structure might be a reduced performance
fee until 250% of losses have been recovered.
Our fee analysis shows that, in many cases,
the comparative cost to investors is negligible.
Extending the performance fee
calculation period
The shorter the period over which performance
fees are calculated and paid to managers
the more the fee terms are skewed in the
managers favour. Consider a situation where the
performance fee is calculated and paid quarterly:
if the manager delivers a strong frst quarter and
three subsequent periods of underperformance,
the manager would still be paid a performance
fee (at the end of the frst quarter) despite
underperforming over the course of the year.
The investor nurses a loss for the year while
the manager enjoys a performance fee.
In seeking to extend the performance fee
calculation period with managers, we aim to
reduce the optionality of the performance fee to
a more balanced structure, aligning the payment
profles of managers and investors during both
positive and negative return periods.
18 towerswatson.com
Clawback provisions
This provision allows investors to claw back
performance fees charged in previous periods
if performance subsequently reverses. It links
the fee to longer-term performance, not a single
year, and means that fees are paid on average
performance over a longer period (of two to fve
years) or at the end of a lock-up period.
Negotiating fee discounts
On the face of it, lower fees are preferable given
that they translate directly into higher net returns.
However, investors should be aware that negotiating
a disproportionately low management fee may
compromise the managers ability to execute its
strategy effectively. In addition, if an investor-specifc
fee is meaningfully lower than that of other accounts,
the managers incentive structure may be distorted
with respect to the allocation of investments.
A fee structure that is far below market levels
may also hamper the managers ability to retain
key investment professionals.
We believe that the terms offered by a hedge
fund manager are of equal importance as fees
in aligning the interests of the manager with
the investor, as we examine in Figure 03.
B. The terms offered by hedge
fund managers
The main terms described in a hedge fund
contract are:
Transparency
Liquidity
Gates
Side pockets
Key man clauses
Initial lock periods.
Below is an explanation of each of these terms
and our views on how each could be negotiated
between the investor and the manager.
Transparency
Hedge funds historically have offered less
transparency than traditional asset managers,
principally to retain any perceived informational
and analytical advantage. This has contributed
to a reputation of secrecy. While we have some
sympathy with this, the dynamic of the industry
has changed and managers must increasingly
respect the fduciary reporting requirements of
institutional investors and their advisors.
The majority of hedge funds will now enter into
detailed discussions of the risks assumed and
signifcant positions within a fund, however,
some continue to offer limited transparency.
We insist on an appropriate level of transparency
in researching and monitoring hedge fund
managers. This can be in the form of access to
key investment professionals as well as portfolio
transparency. Most managers are willing to offer
performance transparency but some are reluctant
to offer full position data, which they consider to
be a trade secret. To improve transparency and
monitor risk more effectively we use a third-party
risk analytics provider that accesses portfolio
information via the administrator. This allows an
independent verifcation of holding and analysis
of the portfolio risk: exposure, sensitivities and
underlying instruments used can all be tracked,
and combinations of managers can be modelled.
Liquidity
Hedge funds typically offer monthly, quarterly
or annual liquidity, and ask investors to serve
a minimum period of notice for redemptions,
normally ranging from 30 to 180 days. We believe
the key concern here is that the liquidity of the
fund refects the inherent liquidity of the underlying
portfolio. In addition, we insist that the majority of
redemption penalties be paid into the fund rather
than to the manager.
Gates
Gates exist to provide stability to the portfolio in
the event of a large number of redemptions at
one time. These can be applied to each investor,
or to the fund as a whole. Investor level gates
can help to mitigate the prisoners dilemma of
pre-emptive redemption requests being placed, as
was witnessed in late 2008. However, fund level
gates, when applied judiciously, can act as valuable
guards to investors interests, ensuring that they
are not left with the most illiquid assets. However,
a manager should frst seek to match the liquidity
terms of the fund with the portfolio assets, rather
than rely on gates to protect the fund.
Side pockets
Some funds have side pocket provisions that allow
them to segregate certain illiquid assets. Side
pocket assets cannot be redeemed by investors
in the same way as others. In most cases it would
be disadvantageous to investors to liquidate the
assets before a particular date or development.
We believe that side pockets do serve a valuable
function as long as the legal documentation is
clear on how they are structured and there is
monitoring transparency. They should not be
used by managers as a way to segregate poorly
performing assets and improve the performance
of the fund, nor should fees be charged on them
for indefnite time periods, particularly if investors
have expressed their desire to redeem.
01 Industry trends
Key man clauses
Hedge funds typically have key individuals who
are critical to the management of the hedge fund
strategy or business. Where a fund is heavily reliant
on key invididuals, and where the fund does not
offer clients ready liquidity, we strongly favour the
use of key man provisions which ensure that critical
personnel remain in place, and in the event of
death, incapacity or resignation, allow investors to
exit the fund. Other clauses could relate to minimum
co-investment levels, or material changes in frm
ownership. Such provisions might include early
redemption rights that loosen lock-up periods and
waive investor fees, or grant investors voting rights.
Initial lock periods
Initial lock periods can exist for a number of valid
reasons, most notably for newer funds allowing
time for the manager to build up the portfolio,
particularly for a strategy that is relatively illiquid.
Additionally, managers may try to attract longer
term investors that believe in and are committed
to the strategy or to secure better terms from their
counterparties.
We believe the lock term should be reasonable
and, critically, that past the lock expiry, liquidity
terms are aligned with the portfolio of assets.
Hold backs
Some funds return 100% of the proceeds from
redemptions to investors within days of the
redemption date. Others hold back 5-10% until
a year-end audit has been completed. For an
investor redeeming in January, an audit holdback
could mean that funds will not be returned for
more than 15 months.
We would prefer to see a reduction in the use of
hold backs, particularly for funds with liquid and
tradable securities. In the case of harder-to-price,
more illiquid strategies, there may be a stronger
case for hold backs.
Active negotiation of fees and terms
We believe that the fees and terms offered by
a hedge fund manager are of equal importance
in aligning the interests of the manager with the
investors. Since the fnancial crisis, we have been
actively involved in negotiating and designing
appropriate structures for our clients. Additionally,
to encourage transparency, our entire list of
favoured managers has been migrated onto a
third-party risk management platform.
We remain mindful that the fee concessions offered
by managers will often come at the cost of reduced
liquidity (generally an initial lock-up period), so we
seek a balance when constructing portfolios of
direct hedge funds. An extended lock in a liquid
equity long-short strategy, for example, is harder
to justify in the context of an overall portfolio that
displays a signifcant degree of illiquidity.
Alignment of interests
strengthens industry
Alpha is a scarce commodity and we expect to
reward managers that are able to produce it
consistently. Those rewards had become skewed
but, since the events of 2008, managers are
more responsive to engaging in discussions with
investors on fees and terms. Many have moved
towards structures that better align the interests
of investors and managers, and this has been
crucial to the revival and growth of the industry.
Figure 03. Terms
Strategy
Notice
period
Lock-up
period
Early redemption
fees
Liquidity
Investor
level
gate
Hurdle
High
watermark Base Performance
Manager 1
Multi-
strategy
Original terms 45 days
2 years + 1
full quarter
N/A Annual No No
1-year loss
carry forward
2.0% 20%
Negotiated
terms
90 days 3 years hard N/A 3 years No
3-month
T-bills
Yes 1.5% 20% (back-ended)
Manager 2
Fixed
income
hedge fund
Original terms 90 days 1 year soft 3% Quarterly
25% per
quarter
No Yes 2.0% 20%
Negotiated
terms
180 days 2 years hard N/A Quarterly
25% per
quarter
LIBOR 6%
cap
Yes 1.0% 15%
Manager 3
Macro
hedge fund
Original terms 90 days
3 years hard
lock
N/A Annual No No Yes 2.0% 20%
Negotiated
terms
90 days
3 years rolling
soft lock
5% if redeemed on
frst anniversary + any
differential with the fees
structure of the other
share class
Annual No LIBOR Yes 1.5% 15% (back-ended)
Manager 4
Equity
long/short
hedge fund
Original terms 30 days 1 year hard N/A Quarterly N/A N/A Yes 1.5% 20%
Negotiated
terms
30 days 1 year soft 4% Quarterly N/A N/A Yes 1.0% 15%
Fees per annum
20 towerswatson.com
Section two
Strategy review
Now that we have reviewed
some of the key structural
trends impacting the hedge fund
industry, we turn our attention to
hedge fund strategies. These, too,
are evolving and what was the case
just a few years ago may no longer
be the case today. In our strategy
review we examine some of the
individual strategies in-depth.
Not all hedge fund strategies represent attractive
investments. The method of access is also
tremendously important. In addition to the decision
of whether to invest in hedge funds and how much,
we believe that each individual hedge fund strategy
deserves detailed scrutiny. Here we explore three
different hedge fund strategies where we have
subtly different views:
Event-driven. We feel that there are a number
of interesting manager opportunities but that a
simple beta strategy is diffcult to structure and
not necessarily additive in a portfolio context.
Managed futures. We feel that there are some
interesting manager opportunities, but that
a simple beta/semi-active strategy may also
complement a traditional portfolio.
Active currency. We feel there are limited
interesting manager opportunities and that
broader macro strategies make more sense.
02 Strategy review
22 towerswatson.com
Event-driven strategies
A decorrelated opportunity set
The key investment driver of event-driven
strategies is identifying the mispricing of
assets due to events such as M&A or corporate
restructurings. Because the outcomes of many
of these events are not driven by economic
factors, many consider event-driven investments
to be decorrelated. A wide range of opportunities
can be contained under the event-driven heading
and many hedge funds look to allocate to some
or all of these strategies from small niche
managers who focus on a particular strategy, to
large multi-strats or specialists within a particular
asset class who use event-driven opportunities to
complement relative value strategies.
Types of event-driven funds
Traditionally, event-driven strategies generally
fall into two categories: merger arbitrage and
distressed debt strategies. This has evolved
now event-driven funds target any perceived
mispricing resulting from corporate actions.
We classify three strategies under the
event-driven umbrella:
Merger/risk arbitrage
Distressed
Special situations.
Merger arbitrage: the original
event-driven strategy
Merger arbitrage is a classic event-driven approach:
investors traditionally bought the stock of a target
company and shorted the equity of the acquirer.
The theory is to exploit the difference between the
current trading price of a target before it is sold
at a premium, and punish a buyer who typically
overpays for the acquisition. The strategy has
evolved to use fnancial and strategic analysis
to determine the potential takeover price, as well
as the use of leverage to amplify returns, requiring
investment banking expertise to judge the likelihood
of successful deal execution. Some managers
employ M&A or management consulting experience
to examine the likelihood of third-party, unsolicited
or broken bids. Legal experts can also be an
attractive addition to an event team, to uncover
break risk and timing issues that could impact
spreads or deal closure.
Distressed investing: exploiting
complex credit situations
Distressed debt focused strategies invest in a
wide range of bonds, bank debt or trade claims
of frms in distress. Hedge funds take a view as
to the likelihood of successful bankruptcy
procedures or agreements with creditors.
Traditionally distressed investors buy distressed
debt at what they perceive to be cheap valuations,
looking for the restructuring event to result in
them holding cash or a different security worth
far more than their original investment. This is
often an arduous process as it requires examining
the motivation of individual credit holders with
various payback priorities on a variety of debt
holdings across the capital structure. The skill
is the ability to source unique investment
opportunities (in litigations, claims resolution
situations, corporate restructurings and
liquidations), to correctly identify the fulcrum
02 Strategy review
security (the security that will gain the most from
the redistribution of the companys value in the
restructuring) and the ability to actively infuence
the restructuring process.
Special situations: extracting value
from non-M&A corporate activity
Special situations strategists seek opportunities
in recapitalisations, spin-offs or carve-outs, using
valuation analysis and timing skills often derived
from corporate fnance experience. This approach
can also be classifed as events with hard catalyst
the catalyst being an episode that can unlock
value, or place stress on the companys balance
sheet. Typically, when a frm announces the
sale or spin-off of assets or units, the proceeds
are returned to shareholders in the form of
increased dividends, share buybacks (resulting in
improved valuations), or via improvement to the
balance sheet (which leads to longer-term share
price gains). Some funds are activist, aiming to
persuade company management to maximise
value for shareholders or creditors.
How to choose an event-driven fund
While the frst step to investing in event-driven
strategies is to understand the strategies
themselves (as described above), the way
in which the strategy is accessed is also
important. A wide range of hedge funds
implement event-driven strategies: from broad
multi-strategy funds who look to time entry and
exit to each strategy; to credit specialists who
will implement distressed debt strategies at
the appropriate stage in the business cycle; to
dedicated single or multi-strategy event funds.
We note that each individual event strategy
tends to be cyclical and as such some of the
more niche players tend not to offer full cycle
investment opportunities.
In addition to selecting the type of fund to access
these opportunities, size can also be important
on the one hand these strategies generally
require signifcant levels of fundamental analysis
and often have a litigation angle, and as such
can be resource intensive. On the other hand,
particularly in equity situations, capacity can be
constrained, as such picking a manager who is
large enough to employ a suffciently resourced
and skilled team, whilst remaining nimble enough
to re-allocate capital and be selective in its stock
selection is critical.
Decorrelated returns
Given that the outcome of corporate events
is often not linked to economic conditions,
event-driven strategies can be a source of
idiosyncratic returns. For example the split of
assets in a liquidation situation is determined
purely in court and the outcome of M&A
transactions is often determined by regulators.
Additionally, for managers with the fexibility to
move in and out of event-driven, and between the
various strategies, there are different opportunities
available throughout a market cycle. In recessionary
environments, distressed investments in corporates
going through liquidations or restructurings can
provide attractive investment opportunities, while
24 towerswatson.com
in economic upswings strong balance sheets
and confdent management can initiate mergers
or distributions of cash to shareholders and
equity event opportunities become an
attractive strategy.
Participation in upswings
In strong growth or low interest rate
environments, there is plenty of opportunity for
equity event strategies. Confdent companies,
armed with cash, are often happy to engage
in takeover plays. It is sometimes a case of
eat or be eaten since those cash treasure
chests look attractive to potential predators
as well. At the same time, inexpensive funding
conditions encourage takeovers by private
equity frms or opportunistic strategic acquirers.
The result is a surge of M&A activity. Positive
economic periods also create opportunities for
corporate turnarounds and company managers
are more willing to take on strategic risks such
as innovative business strategies. Managers
skilled in exploiting equity event situations
can beneft from a range of events in this type
of environment. However, in more diffcult
economic conditions, where there is limited
merger activity and less shareholder friendly
action, equity event strategies can struggle
to allocate capital. Additionally, in market
drawdowns and periods of risk aversion
these strategies tend to suffer.
Opportunities in recessionary
environments
In times of economic stress, where corporate
default rates increase and traditional debt
owners, and certain hedge funds, are forced to
exit positions at distressed prices, managers
who have skill in analysing and infuencing
restructurings and liquidations can fnd very
attractive opportunities. The returns from
distressed investing have been highly attractive
over time, however the timing of allocating to
distressed is critical.
Is there a beta solution?
We feel active event-driven strategies have a
place in a broad hedge fund portfolio because
they are highly dependent on deep skills,
resources and analysis than cannot easily be
replicated. There are also a number of different
strategies, most of which can be successful in
any type of market. A number of event-driven
replication strategies exist that attempt to gain
cheap and simple exposure. For example, one
could create a merger arbitrage strategy that
looks to participate in all announced deals above
a certain size, equally risk weighted. However,
there are several reasons why we feel that it is
more appropriate to gain access through fully
active strategies at present. These include:
Idea generation is not solely based
on company announcements but on
understanding the proft motivations of
various stakeholders: credit owners,
shareholders and company management.
Idea implementation is spread over various
asset classes according to the fund managers
interpretation of corporate events. This requires
investment banking expertise (M&A, capital
markets), strong fundamental analysis, legal
knowledge (antitrust, takeover laws and
bankruptcy proceedings), and trading
experience (liquidity and pricing).
Investment horizons vary from investor to
investor. In a simple merger arbitrage strategy,
the profts from buying the spread of a
takeover and holding it until deal completion
may be improved by trading in and out of the
investment idea, as the spread moves prior
to deal completion.
Strategy evolution: the growth of tools to take
advantage of corporate events.
Leverage used to amplify returns or fnance
the trades can be used to varying degrees and
equity fnancing is often another tool used in
this regard. Idea implementation is executed
over multiple asset classes, meaning that
replicating this strategy via a passive model
is extremely diffcult.
02 Strategy review
Conclusion
We view event-driven strategies as a differentiated
source of alpha and an important component
of a hedge fund portfolio. The skillset required
in managing these strategies requires not just
fnancial expertise, but also legal insight, a
differentiated sourcing network and negotiation
skills. Given that individual event-driven strategies
tend to be cyclical and each event strategy
requires different resources and skillsets, we
believe that funds that can time allocations to
events and dynamically adjust exposures over time
are the best way to access these opportunities.
26 towerswatson.com
Managed futures/systematic strategies
Does quant macro work?
Differentiation between
managed futures and
systematic macro managers
Managed futures managers are quantitatively
driven, trend-following, hedge funds. They
use futures and currency forward contracts to
implement price-based quantitative models.
By contrast, systematic macro managers use
quantitative models that do not completely rely
on price-based signals. For instance, they might
include value models or relative value technical
models. Here, we answer questions about how
these strategies work, whether they add value
relative to fees and ultimately whether they merit
inclusion in a hedge fund portfolio.
Managed futures alpha versus beta
There are a wide variety of trend-following models
pursued by managed futures managers, these
are based on technical price indicators ranging
from simple moving average crossover
techniques (for example, two moving averages
with different time horizons cross, leading to a
trend signal) to much more complicated methods
based on up-to-the-minute academic thinking.
In practice, for the vast majority of managed
futures strategies there is a signifcant overlap
in the indicators used, which leads to a high
degree of correlation between managers. The
correlation between managed futures managers
is typically in excess of 0.6 (1 is complete
correlation). If this is true, then why not invest in
a simple, easily understandable, trend-following
model for a modest management fee? Several
such products exist already and are sometimes
termed alternative beta. In many cases, we
believe that a simple, low- cost trend-following
solution is a sensible choice when constructing
a hedge fund portfolio.
However, whilst the correlation between many
managed futures managers is high, there is
meaningful dispersion between the best and worst
performers. We believe that certain managers can
differentiate themselves signifcantly, particularly
through their systems, risk management, liquidity,
trading costs, research processes and importantly
capacity management. But in reality, do these
things actually increase value to investors?
Picking the best performer out of the managed
futures managers with assets in excess of
US$5 billion would have returned around 3 to 4%
a year more over the recent fve year period from
2007 to 2011 than picking the poorest performer.
(Notably, all managers in this investment strategy
have generated attractive absolute returns during
the period.) This suggests that managers are
applying different controls with different levels
of success to their models. So managed futures
funds are not clones, even if at least a portion of
the return of most managers could be accessed
simply and cheaply.
The classic rationale for the persistence of
trends relies on behavioural fnance the herding
behaviour of investors. There is a vast array of
academic literature to back this up and the back
tests for managed futures performance look
impressive. But the fact that there is dispersion in
the performance of managers is not suffcient to
02 Strategy review
merit investment in a fully active managed futures
fund. To merit fees above what are charged for a
simplistic beta alternative, the manager needs to
have fundamental beliefs and a genuine edge that
can lead to outperformance. Whilst the underlying
indicators used are important, there are several
other very important factors to consider when
assessing a manager.
Are trend strategies valuable in a
portfolio of direct hedge funds?
If you believe in the herd instinct then
trend-following in some form may sound like
a plausible and attractive strategy. But it
should only be used in the portfolio context.
Historical managed futures returns are
uncorrelated to other hedge fund strategies
and other mainstream market betas, but could
we not go through an extended period where
trend following or other systematic models do
not work? Of course we could! Indeed, the
choppy markets of 2011 were diffcult for many
managers to navigate. The diffculties might also
stem from the increase in assets invested in
trend following strategies.
Systematic macro is there a beta
alternative here?
It is slightly different for systematic macro
managers. There is signifcant overlap in the
underlying indicators here too, but there is also
a different mix of alternative betas (an example
would be currency carry or purchasing power
parity). Systematic macro managers are not clones
either, but you could build a portfolio of simple and
easily understandable alternative betas that go
some way to explaining the returns of a number
of the underlying models.
The fundamental justifcation for systematic macro
models is easier to make than for trend followers
identifying something that is undervalued seems
to make more sense than simply following a
positively sloped price trend. An analysis of the
underlying beta exposures of a systematic macro
manager is still important though. Of course, it
may be that the manager is generating returns
based purely on differentiated models.
Researching quantitative strategies
Finding a defnitive edge in a managed futures or
systematic macro manager requires differentiated
manager research techniques. It involves
reviewing systems, speaking to traders, running
through quantitative models and understanding
quantitative research processes. Knowing if that
edge actually adds value is perhaps even harder.
It requires an understanding of why the model
should work, making sure that the research
processes are not biased and an understanding
of the reasons behind the risk controls and trading
techniques. After all that, there is still a probability
that the models simply do not achieve what is
claimed. In other words, after fees, they do not
beat a simple, easily understandable model.
In addition, we need to be sure that we receive
enough transparency on complex active
systematic processes before we get comfortable
with them. This means transparency in several
respects: meeting researchers and traders,
understanding model examples, viewing systems
and infrastructure.
There are few managers in this category that
can generate suffcient risk-adjusted returns
as a result of an edge in model building, model
evolution, trading, risk management and systems.
A fork in the road
Our research into managed futures and
systematic macro managers has led us down
two paths. First, the signifcant overlap between
the models used leads us to favour simple,
low-cost, transparent quantitative models that
employ active risk control, strong systems and
a thoughtfully designed trading platform. We
would term this a semi-active alternative beta
solution. Second, sometimes the fees associated
with certain fully active systematic managers are
justifable, but there has to be clear evidence of
an edge as well as appropriate transparency.
28 towerswatson.com
Active currency
A genuine hedge fund strategy?
Since the currency market is the largest fnancial
market, with an average daily turnover of around
US$4 trillion
1
, it is inevitable that it attracts a great
many hedge fund strategies and managers. The
market is characterised by high liquidity and low
trading costs, which suggests it is highly effcient.
This, coupled with the fact it is a zero-sum
2
game,
would suggest that there is no obvious underlying
return that investors can exploit in the long term.
There have been numerous studies, however,
that suggest the foreign exchange market does
not correspond to the defnition of even a weak
form of market effciency. This is usually explained
by the fact that market participants such as
governments, corporate treasuries, tourists
and so on, do not have the maximisation of
profts as their primary objective. Additionally,
structural ineffciencies exist due to the absence
of a centralised exchange. Proponents of active
currency management believe that a skilled
manager can exploit these ineffciencies and
generate sustainable positive returns.
Simplistic strategies can be effective
Various academic studies have explored the
risk-return characteristics of simplistic investment
strategies in the currency market and have found
that some of them deliver statistically signifcant
1 Source: BIS, 2010
2 When taking all currencies into consideration, the appreciation in
certain currencies over any given time period should be offset by
equivalent deprecation in other currencies.
02 Strategy review
positive returns over time. Some of the most
common examples are the carry trade
(based on holding a basket of high yielding
currencies, funded by lower yielding currencies),
trend-following (for example, based on simple
moving average crossover techniques) and value
(for example, based on a crude measure of
Purchasing Power Parity). If something is easy to
replicate and widely used, we do not think it merits
hedge fund fees. But can it be replicated?
There are few widely accepted indices following
currency investment strategies. The exception to
this is the carry trade, which has gained some
traction with index providers (for example, the
S&P Currency Arbitrage Index and the FTSE FRB10
Index). There are also several providers that offer
products in this area. The availability of widely-used
indices and investment strategies tracking those
indices makes it easier to assess whether active
currency strategies are adding value.
Does active currency management
add value?
Foreign exchange managers are often categorised
by the nature of the factors that drive their
investment decisions (technical versus fundamental,
for instance) and the way specifc trade decisions
are taken (discretionary versus systematic).
Managers that focus on technical analysis use
historical exchange-rate-based measures and
charting techniques in order to predict if a given
currency will appreciate or depreciate versus
another. At the other extreme, fundamentally-
driven managers focus on defning the fair value
of a currency based on economic measures.
With regard to the way trade decisions are taken,
systematic managers trades are driven by
rule-based models whereas discretionary
managers are driven by human decisions.
Currency managers normally offer active currency
products under active overlay programmes and
stand-alone active products which are often
labelled as absolute return. Let us take a closer
look at these products and assess their merits.
Active overlay
Active overlay products are a mixture of a passive
approach to hedging a predetermined portion
of a portfolios foreign exchange exposure
and an absolute return currency management
programme. Under an active overlay programme,
the investor sets boundaries around the strategic
hedge ratio, within which the manager can take
active bets. These are often symmetrical so that
the currency manager can express both bullish
and bearish views with regard to the foreign
currency. For example, a sterling-based investor
that has exposure to the US dollar may set up
a strategic hedge ratio of 50% with +/ 25%
maximum tactical deviation boundaries.
Active overlays are normally relatively inexpensive.
However, there are caveats: unless structured
carefully with appropriate risk limits, active overlay
mandates can represent a signifcant portion of
the active risk in a given portfolio. In addition,
most active overlay programmes are limited to
the foreign currencies to which the investor is
exposed. Yet, often, the manager is assigned to
manage only a small number of currency pairs (for
example GBP/EUR and GBP/USD). This results in
a somewhat paradoxical situation. If the investor
believes in the skill of the currency manager to add
return, then why limit the manager to only a few
currency pairs? As a result of these issues, we fnd
it diffcult to be favourable towards active overlay
mandates and our preferred recommended course
of action is passive currency hedging, according to
a carefully-chosen strategic hedge ratio.
Absolute return
Given the relative value nature of currency trades
and the use of leverage, we consider absolute
return currency strategies to be frmly in the hedge
fund camp. They tend to be liquid strategies and
relatively transparent and they also tend to have
hedge fund fee structures. However, we feel that
the vast majority of absolute return currency
products look at similar factors or indicators.
Often, these are similar to the simplistic strategies
discussed above, suggesting that hedge fund fees
are unwarranted. However, we do recognise that
highly-skilled currency managers can generate
meaningful alpha. Even if they have an approach
based on a simplistic strategy, models can be
developed to have differentiating features. They
can also employ differentiated risk management
techniques, have superior trading and portfolio
management systems and be better informed on
liquidity and transaction costs.
Incorporate into a portfolio as
part of broader macro strategy
We recognise that there are a number of high
quality standalone active currency offerings.
However, due to the relatively narrow scope of
such strategies, it is unlikely (but not impossible)
for a dedicated currency manager to be part of a
concentrated portfolio of 10-15 direct managers.
In such a portfolio, we consider access to currency
skill through a broader macro or multi-strategy
hedge fund to be more appropriate.
30 towerswatson.com
Section t hre
Hedge funds for less
03 Hedge funds for less
We have already talked about several simple alternative beta strategies in
our strategy reviews: they can provide low-cost and transparent access to
hedge fund-like return streams. There are also a number of other strategies
that are decorrelated to major market indices and yet can be accessed
outside of the hedge fund sector. This section looks at the investment
merits of some of these ideas and how they can be accessed.
Reinsurance. This strategy has low correlation to most other assets, but
is not for the faint-hearted. Investors collect healthy levels of premium for
long periods but then can suffer sudden large drawdowns. Over the long
term, the strategy has tended to pay off.
Emerging market currency. The long-term fundamentals for this strategy
are strong so paying active management fees is not necessarily the
sensible path for investors.
Volatility. This is an esoteric strategy that can be hard to fathom at frst
sight. But it is worth persevering: accessing the risk premium in implied
volatility adds value to portfolios, reduces overall portfolio risk, but is not
totally decorrelated from the principal asset classes.
While the theoretical argument for investing
in hedge funds is clear, fees can be high.
They act as a drag on portfolio performance,
particularly at a time when many assets have
low yields.
32 towerswatson.com
Alternative beta
An introduction
The wider range of liquid, market-traded
instruments available today broadens the range
of alternative return drivers that sophisticated
institutions can access. As markets become
more commoditised and transparent, it becomes
possible to implement strategic allocations to
these drivers in a more systemic way than through
traditional hedge funds. Investment opportunities
and risk premia that were previously accessible
only through hedge funds, can now be accessed
in a simple and cost-effcient way.
Many institutional investors have had exposure
to asset classes that we now call alternative
beta for a long time. In a traditional investment
model, portfolios are split between bonds,
equities and alternatives with the latter category
often including one or more fund of hedge funds
and/or direct exposure to hedge funds. Investors
would look at fund of hedge funds as a source
of broad portfolio diversifcation effectively a
one-stop shop for alternative and diversifying
assets and returns.
As the hedge fund industry developed,
investors started to analyse returns, strategies
and exposures in much more detail. Looking at
a cross-section of funds revealed a number of
commonalities across managers and highlighted
a number of strategies that investors could
replicate themselves. The high level of fees of
funds of hedge fund structures was an obvious
motivation for a number of investors to seek
cheaper replication, or alternative betas.
To us, this appears to be part of a healthy
evolutionary process. Hedge funds operate
at the cutting edge of fnancial market
innovation, continually exploring new asset
classes and trading strategies. Some of their
investment strategies are therefore temporary
or opportunistic in nature and some will end up
losing money. However, a range of investments
will be proftable over the longer term. New
strategies are publicised by practitioners and
academic researchers and are then tested by
a range of other investors. So volumes in that
market rise and the costs of access diminish.
Techniques and asset classes previously used
only by active managers become commoditised,
allowing sophisticated investors to allocate to
them directly.
We see no single, satisfactory defnition of
alternative betas, particularly as the list keeps
evolving. In general terms, though, we think
about it as a rewarded risk factor that investors
can access through a buy-and-hold strategy or
a mechanistic trading strategy. In many
cases, alternative betas blur the difference
between passive and active management,
combining non-standard indices with a
degree of active management.
Benefts of allocating to
alternative betas
There is little question that alternative beta is
a valuable addition to investment portfolios
and that the diversifcation they provide will
enhance portfolio effciency.
Transparency and clarity of the risks taken are
indeed a big advantage for portfolio construction.
As investors are able to understand the risks
that are being taken, they can gain greater
comfort in these asset classes and will be able
to allocate a bigger share of their portfolio to
these risks than in the FoHF model. Another
incentive for allocating to alternative betas is cost
savings. Investors should pay alpha-like fees for
alpha returns and beta-like fees for beta returns.
As this implies, alternative beta tends to be
more expensive than conventional asset classes
but less expensive than active management
products. Lastly, many alternative betas are
implemented through liquid instruments so
helping to manage overall portfolio liquidity.
The alternative beta
investment process
The process to research, approve and invest
in alternative beta differs signifcantly from the
hedge fund approach. The majority of our research
focuses on analysing the investment strategy and
deciding if there is truly a long-term risk premium
to be captured. We rely on a multitude of evidence
and checks as part of our due diligence for new
alternative betas. This involves discussions with
practitioners and academic researchers, as well
as detailed desk-based research using our own
analysis and back-testing of historic market data.
First, alternative betas need to be established
investment ideas that have been used by a
number of investment institutions for an extended
time period and have withstood the test of
time. There is typically a signifcant amount of
academic and practitioner literature so we need
to be satisfed that increasing understanding of
and fows to the strategy do not eliminate return.
This is a key Litmus test that can help to flter out
arbitrage trades and opportunistic investments.
Second, it is important to understand the
economic source for a long-term, sustainable
return which is typically in exchange for taking on
a non-standard risk. In a number of cases returns
for alternative betas are driven by markets that are
structurally one-sided typically driven by demand
for hedging and risk management with no obvious
counterparty. In these cases, some institutions
are willing to pay a premium in exchange for a risk
reduction, while investors with no initial exposure
can take on some risk and earn the premium.
Third, there needs to be a suitable implementation
option. Given that the investment proposition is
likely to be new, it is often hard to defne a clear
benchmark or index to follow. Considerable effort
is needed to defne the investment strategy. In
some cases, this may include deciding between a
purely mechanistic or passive implementation and
a semi-active implementation involving qualitative
judgement. Cost effciency is an additional,
important requirement: most alternative beta
ideas use derivatives and the over-the- counter
market and thus require a more advanced
execution and trading capability than for traditional
asset classes. This often implies that alternative
betas are more expensive to implement than other
passive assets.
Compared to hedge funds, however, there
remain signifcant advantages with regards to
implementation. Alternative betas will rely less
on individual investment professionals and their
incentives, reducing the importance of identifying
skilled individuals and monitoring their behaviour.
Investment systems and infrastructure are
important for alternative betas but, compared
with hedge funds that require a best-in-class
infrastructure as part of their competitive
advantage, alternative beta requirements are
lower as execution intends to limit operational
risks rather than generate outperformance.
Ongoing monitoring is a relatively straightforward
process. But it is still important to monitor many
of the things we look for in active managers (such
as appropriate resource levels and normal levels
of team turnover) as well as to review the strategy
against its return expectations. Compared with
hedge funds, we expect the turnover of alternative
beta ideas and managers to be low.
So will alternative beta strategies
replace hedge funds?
Using alternative betas in a portfolio raises the bar
for hedge funds. To prove their worth, hedge funds
need to show they can generate truly uncorrelated
alpha. This will involve a continuous process of
innovation, using newly developing asset classes
and focusing on trading strategies that cannot
be easily replicated. In our experience, only a few
managers can offer truly differentiated strategies
and it is hard to identify them. Investors that
succeed in fnding them can combine alternative
betas and an allocation to a hand-picked selection
of high quality hedge funds that will substantially
improve portfolio effciency.
34 towerswatson.com
Reinsurance
Strong stomach needed for proven strategy
Asset classes with a low correlation to equities are
very attractive within portfolio construction. Writing
protection for a number of global, mostly natural,
catastrophes is one of the few cases where
investors are compensated for risk that is largely
uncorrelated with equity markets. While we are
looking for straightforward exposure to reinsurance
beta, private market structures and the absence
of suitable indices require active management in
implementing this strategy.
Insurance policyholders have to pay above-the-odds
for protection. Insurance premia tend to be
expensive because they need to compensate
the insurance company for its overhead costs
and also because the potential bearer of the
insurance loss will want to earn a signifcant
premium for the risk it is taking. The return
profle of insurance differs from most other
asset classes. Most of the time, the underwriter
generates positive returns based on the earned
insurance premium, but occasionally the
insured event materialises and causes a sharp
drawdown. However, while returns have a fat
left-tail, well-written insurance contracts are
usually proftable for the underwriter in the
longer term.
The investment case
While it is comforting to know that investors can
expect to earn a premium over time from investing
in reinsurance, we think that the low correlation of
the asset class with conventional assets is more
interesting still. Most other conventional and
alternative asset classes show some degree
of correlation with each other, either because the
risk premia are effectively driven by the (global)
business cycle or because they are sensitive to
risk aversion.
The low correlation of reinsurance with other
assets is intuitive: neither a fnancial market crisis
nor a recession causes earthquakes or hurricanes.
We acknowledge that some severe catastrophes
may have an impact on the economy, but history
suggests these are short-lived and limited to
a relatively small geographical area. Generally,
natural catastrophes have no marked effect on
global fnancial markets.
What types of insurance risk
are attractive?
The insurance industry works based on the
principle of diversifcation. For a typical insurance
portfolio consisting of, for example, auto-liability
insurance contracts, the insurance company would
expect a certain percentage of cars to be involved
in accidents during a year. But as these accidents
are independent events it is unthinkable that
all car owners would crash their cars at the same
time diversifcation and the law of large numbers
works well in reducing overall risk. Given a large
number of policies, an insurance company could
predict the aggregate number of accidents with
some precision, leaving little uncertainty around
its aggregate liability each year.
Diversifcation does not work for all types of
insurance though. When a single event may trigger
a range of policies, diversifcation fails and the
insurance company will be left with an outsized
risk and a potentially large, unexpected loss.
Earthquakes and severe winds like hurricanes
are prime examples, since they have the potential
to trigger a large number of property insurance
contracts at the same time.
To protect policyholders, regulators require
companies to either hold capital against these
tail events or to purchase protection themselves
from reinsurers. The opportunity for capital market
investors is two-fold. First, the number of global
event risks remains too big to be fully absorbed
by the reinsurance industry. For the most part,
they are related to natural catastrophes, like
signifcant earthquakes or extreme wind/hurricane
events. These risks thus command a consistent
and signifcant risk premium (the corresponding
insurance premia tend to be a multiple of the
expected losses).
Second, some risks are unattractive for insurance
frms to keep on their own balance sheet, given
their required return on equity (RoE) which is
typically above 10%. Insurance regulation (most
recently Solvency II requirements) demands that
the industry holds equity capital as protection
against extreme events. In reality, the tail risks
of insurance frms are based on a number of low
frequency events with a small expected loss
(of up to 2 to 3%). While the premium may
compensate the frm well for the risk taken, it still
falls short of the high RoE requirement and the
frms would therefore prefer to remove the risks
from their balance sheets in order to free up equity
capital and boost relative returns.
Capital market investors and most institutional
investors tend to have more modest return
expectations and little initial exposure to
insurance risk. Adding low frequency insurance
risks driven by large, natural catastrophes that
are well-rewarded given the risks involved, can
improve return expectations and will diversify
capital market-based portfolios.
The main reinsurance instruments
Investors can obtain exposure to reinsurance
through a range of instruments, including
catastrophe bonds, industry loss warranties
(ILWs), direct reinsurance and retrocession
contracts. All of these investments are structured
to provide investors with pure exposure to the
underlying insurance risks there is typically
no credit exposure to the insurance companies
and the underlying assets are held in low-risk
bonds, often US Treasuries.
Catastrophe bonds are securities, similar to
corporate bonds, for which the credit risk is not a
corporate default but a loss caused by a natural
catastrophe. They are simple to invest in but the
market is still growing, and its current size of
US$14 billion means it offers limited liquidity.
ILWs are derivative contracts with a payout trigger
that is linked to industry-wide insurance losses
a transparent loss measure without a link to the
idiosyncrasies of a bespoke portfolio. They are
standardised products that allow for a risk transfer
at short notice and without detailed due diligence.
Lastly, direct reinsurance and retrocession
contracts are private market deals that provide
protection on bespoke portfolios of insurance or
reinsurance risks. This is by far the most signifcant
transaction type. However, the bespoke and private
market nature of the transaction requires sourcing
and due diligence skills and is more time-consuming
and expensive in its execution.
We fnd that all of the above instruments can play
an important role in a balanced insurance risk
portfolio. Over time, the suitability of each may
change and we prefer mandates that can explore
changes in relative pricing.
Gaining access to
reinsurance investments
There is no established and investable index
for reinsurance. This is unsurprising given that
reinsurance is a relatively new asset class and
involves signifcant private market transactions.
It implies that implementation will need to
follow a number of bespoke rules and should
be considered as an active investment.
Insurance risks from the various risk perils
are uncorrelated (hurricanes do not cause
earthquakes) and assuming a multitude of
insurance risks will reduce portfolio risk.
Managers also use state-of-the-art risk
modelling detailed analysis highlights further
diversifcation potential within some of the main
risk perils. Best-in-class portfolio management
combines a variety of rewarded insurance risks
and uses quantitative tools to monitor and
manage left-tail risks.
Given that a signifcant part of the market consists
of private market transactions, best-in-class
managers will have the ability to source deals
as well as the resources and skills to perform
due diligence on transactions. Access to private
markets improves capacity for managers and it
can also enhance returns as investors get
rewarded for taking the basis risk (for example,
for underwriting the losses of a specifc insurance
portfolio, as opposed to the average portfolio).
In our experience, managers require infrastructure,
scale and experience to successfully execute
private market transactions.
Sizing an allocation
Given the uncorrelated nature of the asset class,
an unconstrained optimisation of an investors
portfolio would suggest a signifcant allocation
to reinsurance. However, other considerations,
including liquidity and capacity, make us believe
that the right percentage allocation for most
investors should instead be in the single-digits.
Reinsurance offers some potential for dynamic
asset allocation. It remains nearly impossible
to forecast natural catastrophes: geologists still
cannot forecast earthquakes and meteorology
forecasts for the hurricane season remain weak.
Nevertheless, the premia paid for these risks vary
over time and thereby vary the attractiveness of
insurance as an asset class. Premium levels are
subject to long-term reinsurance cycles which
depend on the capitalisation of the industry. In
other words, insurance is an attractive investment
when the reinsurance industry is short of capital.
An allocation can be managed across the
reinsurance cycle. This means that investors need
to allocate to the asset class soon after a severe
catastrophe and take profts when catastrophe
activity has been benign. However, we fnd that
it is hard in reality for most investors to increase
their allocation just after they have suffered
signifcant losses themselves.
36 towerswatson.com
Emerging market currency
Persuasive long-term fundamentals
Investing in emerging market currency essentially
entails purchasing currency forwards (including
some non-deliverable currency forwards),
cash investments and very short-dated bonds
denominated in emerging market currencies.
We expect emerging market currencies to
outperform developed market cash returns as
a result of productivity differentials, higher real
interest rates and the fact that the value of some
emerging currencies has been suppressed by
central authorities through currency pegs. While
we feel that exposure to a range of different
emerging market investments makes sense,
including debt and equity, the above phenomena
lead us to believe that emerging market currencies
are particularly attractive over the long term.
Investors can access emerging market currencies
through a long-only product or a hedge fund
strategy. Long-only products are typically
benchmarked against some commonly used
indices. However, these indices have some faws.
There are, for instance, low limits on
non- deliverable currencies and there is a
resultant bias towards Latin America where
the currencies are generally free foating. The
products are also normally denominated in
US dollars and annual management fees are in
the region of 40 to 80 basis points. There are
benefts associated with diversifying the funding
currency across a range of developed currencies,
not just US dollars. We also believe that the long
exposures to emerging market currencies should
be better diversifed by geography, including
greater exposure to Asian currencies.
Emerging market currency is a long-term
investment theme and a customised, lower-cost
buy-and-hold strategy is something that we feel
gives good access while avoiding a number of the
structural issues. Active management can also
work in an ineffcient asset class like emerging
market currency, but we believe that it is most
important to maintain good diversifcation with
sensible risk oversight.
Exposure to emerging market currencies through
hedge funds could be via a dedicated strategy
or a broader emerging market or macro manager.
Products will often have a long bias and charge
hedge fund fees. We have developed high
conviction in several broader macro managers
where emerging market currency is a part of the
opportunity set. Other than that, we have yet to
be convinced that dedicated emerging market
currency managers are able to generate enough
alpha over and above a simple buy-and-hold
approach. While some managers have exhibited
a modest edge, we have met numerous managers
in this asset class and feel that many of the
models and processes used are similar.
There are several risks associated with emerging
market currencies. Not least, the risk that the
investment theme does not play out as expected.
The fnancial situation of banking institutions
in Europe is one example of why it might not.
A number of emerging market economies are at
least partly reliant on European banks for funding
so there is some contagion risk. In our view, this
is a clear argument in favour of a well-diversifed
portfolio. Political risk could also be a problem
emerging market mandates have traditionally
been prone to this risk in the past since the
ability and willingness of the central authorities
to make debt repayments is at stake. Additionally,
counterparty risks need to be managed and there
is also a range of idiosyncratic risks relating to
each individual currency.
A semi-passive approach could
be optimal
Emerging market currency is an attractive
long-term investment theme. A simple,
semi-passive solution can give good access
to this theme without the need to pay active
management fees. In the hedge fund world,
there are skilled managers but this strategy
is, we believe, best accessed through broader
macro products.
38 towerswatson.com
Another alternative beta opportunity provides
exposure to the volatility premium as a
sustainable return driver. What is the volatility
premium? The vast majority of option demand
from investors is long volatility meaning that
investors buy options rather than sell them.
The volatility premium is a result of this one-sided
market and is illustrated by the observation that
implied volatility tends to exceed realised volatility.
As you will see, investors can use this premium
as a good source of returns at low cost relative
to many hedge fund strategies.
Similarly to other carry strategies and reinsurance,
this strategy requires courage. Most of the time,
the strategy generates positive returns based on
the volatility premium, but occasionally volatility
spikes and causes a sharp drawdown.
Defning the volatility premium
Equity market volatility is a measure of the risk or
variability of prices in equity markets. There are two
types of equity volatility:
1. Implied volatility describes the level of volatility
that can be deduced from market prices of traded
derivatives. It is a forward-looking measure.
2. Realised volatility is calculated from actual
(typically daily observed) movements in the
underlying index or share. It is a backward-looking
measure based on the actual variability in equity
market pricing.
The most popular estimate of implied volatility,
the VIX index, is calculated using a range of
S&P 500 options traded on the Chicago Board
Options Exchange.
Historical evidence shows that realised volatility
has consistently been lower than implied volatility.
The estimate of equity market volatility implied in
options has traded at a premium. While implied
volatility exceeds realised volatility most of the time,
the difference between the two measures does
vary. Realised volatility is subject to occasional
shocks that cause it to exceed implied volatility at
times of market stress. We fnd that the distribution
of the difference between implied and realised
volatility shows an insurance-type profle with
positive premia followed by occasional draw-downs,
as illustrated in Figures 04 and 05.
Why should there be a premium
in volatility?
To understand the premium in volatility markets
requires an understanding of the market dynamics
in equity options. Investors will predominantly be
buying options as a hedging instrument on top of
an existing equity allocation, or as a substitute for
equities and to obtain a capped exposure to equity
markets. Investment banks tend to be the sellers of
these instruments and in general, given the hedging
demands of their clients, tend to sell more equity
puts than calls. Outside of investment banks there
are limited market participants selling volatility,
however there is a signifcant and consistent
demand for volatility.
Volatility
Clear premium: diversifying?
We think the observed difference between implied
and realised volatility is based on a structural
imbalance in fnancial markets. Many investors
buy put or call options to hedge or gain exposure
to equities. Banks will accumulate the volatility
risk that results from these trades on their trading
books as their structuring desks are writing
option contracts. However, there is no natural
counterparty that would want to take on volatility
risks and banks thus fnd it diffcult to offset their
exposure to volatility. Equity options and similar
derivatives tend to be expensive as banks need to
be compensated for taking on unhedged volatility
risk. Similarly, they are willing to pay a premium
for volatility protection.
The existence of a risk premium in implied
volatility is now well accepted, both in
practitioners analysis of volatility markets
as well as in academic literature.
1
Figure 04.
Source: Bloomberg, Towers Watson
Figure 05.
Source: Bloomberg, Towers Watson
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9
6
9
7
9
8
9
9
0
0
0
1
0
2
0
3
0
4
0
5
0
6
0
7
0
8
0
9
1
0
1
1
Realised S&P 500 volatility VIX (Implied S&P 500 volatility)
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
9
0
9
1
9
2
9
3
9
4
9
5
9
6
9
7
9
8
9
9
0
0
0
1
0
2
0
3
0
4
0
5
0
6
0
7
0
8
0
9
1
0
1
1
Historic difference in implied vs realised SPX vol
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
1 The volatility risk premium is sometimes considered as one of the main rewarded risk factors, see Ang, Goetzmann, Schaefer, 2009, Evaluation of Active
Management of the Norwegian Government Pension Fund Global. The academic literature analysing the volatility risk premium includes Bakshi and
Kapadia, 2003, Delta-Hedged Gains and the Negative Market Volatility Risk Premium, Review of Financial Studies, 16(2), Bollerslev, Gibson, and Zhou,
2011, Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option-Implied and Realized Volatilities, Journal of Econometrics 160(1)
or Carr and Wu, 2009, Variance Risk Premiums, Review of Financial Studies 22(3).
Figures 04 and 05 illustrate how realised volatility has been higher than implied volatility for long
periods of time.
40 towerswatson.com
Gaining access to volatility
The most direct and common instrument used
to gain pure exposure to equity market volatility
is a variance swap
2
, which is an over-the-counter
derivative. As with other swap contracts, the
variance swap has a fxed leg which is based
on the implied equity market variance and a
foating leg which is based on the realised equity
variance. Banks buy variance swaps (paying
implied variance and receiving realised variance)
as this provides them with protection against
unexpected increases in volatility. Investors can
sell variance swaps (receiving implied variance
and paying realised variance) as a direct way to
access the volatility premium.
An alternative route is to imitate the positioning
of the trading desks at banks: an investor
can sell equity options and delta hedge the
directional equity market exposure. The resulting
portfolio will generate a similar exposure to the
volatility premium.
The pros and cons of trading volatility
As with other insurance strategies, investors will
suffer losses if the insured event materialises
in this case if volatility spikes unexpectedly.
However, historic data shows that the premium
collected at benign times exceeds the occasional
losses from volatility spikes as would be
expected from a risk premium.
Nevertheless, an unprotected volatility strategy
can still suffer from occasional, large drawdowns.
Intelligent structuring of the investment is helpful
to alleviate some of this downside in our view.
A helpful feature of variance swaps is that they
commonly cap the maximum exposure. This feature
is hard-coded into the swap contract, so there is
certainty on the worst-case outcome this means
that investors can fx their maximum loss. Where
the loss cap is priced into the variance swap
contracts, investors should expect commensurately
lower returns. Our analysis suggests that the cost
of a loss cap leads to only a modest reduction in
the risk premium.
Rising volatility is correlated with falls in equity
markets, but this relationship is far from perfect.
Firstly, returns from the strategy depend on the
initial level of implied volatility. If market pricing
already assumes an elevated level of market risk,
then implied volatility will go up and higher realised
volatility will not necessarily harm returns. Thus,
a strategy exploiting a volatility premium tends to
suffer losses when volatility initially spikes. But
as implied volatility will also increase at this time,
returns in the subsequent periods would require
volatility to rise even higher for the strategy to
record losses. Secondly, volatility tends to go
up when equity markets fall, but not always.
Historically, we have observed times when equity
markets have fallen, or range-traded for years,
while volatility has not markedly increased.
Reductions in portfolio risk, but not
complete decorrelation
We recognise that the volatility premium can be
highly correlated to equity markets in periods of
market stress where volatility tends to spike. As
such, drawdowns in this strategy tend to occur at
the same time as drawdowns in other risk asset
allocations. However, there are a multitude of
scenarios where volatility premium provides helpful
diversifcation. For example, the bursting of the
technology bubble in 2000 to 2002 led to equity
markets such as the S&P 500 falling by over 40%,
while a volatility risk premium strategy would have
produced positive returns over the same period.
In addition, Figure 05 indicates that the volatility
premium is fairly stable over the long run and not
subject to lengthy drawdowns. Equity markets, on
the other hand, can suffer prolonged bear markets
when valuations fall and investors suffer losses for
extended periods.
It should be noted that all insurance strategies
are limited in their upside potential. Although
we see a strategy that accesses the volatility
premium as a suitable alternative to an equity
allocation, the limited upside implies that
the strategy underperforms equities in bull
markets. On the other hand, it is possible for
outperformance to be generated in bear markets
and in fat market environments.
2 Variance is the square of volatility. Volatility swaps exist, but variance
swaps are much more common. The two instruments are closely linked.
Summary
Hedge fund research
Time and effort well spent
Alpha opportunities do exist, even as volumes in
many markets rise, and we believe investing time
and resources in identifying these opportunities and
formulating the right way of accessing them will be
amply rewarded. Equally, there are strategies that
provide decorrelated returns with indices that do not
necessarily require investors to invest in hedge funds
and pay hedge fund fees.
Towers Watson has considerable expertise in this area
and for years has helped clients to navigate their way
through the issues. But we recognise there are no right
or wrong answers and that this publication forms part
of an ongoing dialogue about the options available.
In that respect, as in others, we look forward to your
feedback and comments.
For further information please contact:
Damien Loveday
Damien.Loveday@towerswatson.com
+44(0) 207 227 2408
We hope the information and
analysis in the publication will
be helpful to you in your future
deliberations over hedge fund
allocations. This paper, we think,
demonstrates that there is no single
way to invest in hedge funds,
no single strategy that suits all
investors and that there are a lot of
considerations to take into account
when doing so.
towerswatson.com
Disclaimer
This document was prepared for general information purposes only and
should not be considered a substitute for specifc professional advice. In
particular, its contents are not intended by Towers Watson to be construed
as the provision of investment, legal, accounting, tax or other professional
advice or recommendations of any kind, or to form the basis of any
decision to do or to refrain from doing anything. As such, this document
should not be relied upon for investment or other fnancial decisions and
no such decisions should be taken on the basis of its contents without
seeking specifc advice.
This document is based on information available to Towers Watson at
the date of issue, and takes no account of subsequent developments
after that date. In addition, past performance is not indicative of future
results. In producing this document Towers Watson has relied upon the
accuracy and completeness of certain data and information obtained
from third parties. This document may not be reproduced or distributed
to any other party, whether in whole or in part, without Towers Watsons
prior written permission, except as may be required by law. In the absence
of its express written permission to the contrary, Towers Watson and its
affliates and their respective directors, offcers and employees accept no
responsibility and will not be liable for any consequences howsoever arising
from any use of or reliance on the contents of this document including any
opinions expressed herein.
Copyright 2012 Towers Watson. All rights reserved.
TW-EU-2012_25068 April 2012.

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