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The Hedge Fund Landscape Our Latest Thinking The Hedge Fund Landscape Our Latest Thinking Table of Contents Introduction: Industry Seeks Rapid Evolution 2 Managed Accounts: An Evolution 3 The Alternative UCITS Market: The Power of Perception 6 Hedge Fund Fees: Toward a Fairer Deal 18 Activism: Strategy Overview 22 Improving the FoHF Model 28 Hedge Fund Portfolio Construction: Key Considerations 30 Into a New Dimension: An Alternative View of Smart Beta 36 Summary: Hedge Fund Research: Time and Effort Well Spent 44 The Hedge Fund Landscape: Our Latest Thinking 1 Introduction Industry Seeks Rapid Evolution Since we began researching hedge fund strategies in the late 1990s, we have witnessed considerable changes in both the industry and markets. Economic and financial crises combined with extreme volatility, and difficult 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 now exceed US$2.6 trillion as of 2014, and many expect the industry to continue to grow, especially as more institutions seek diversity within their plans.* 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 flow of assets into direct hedge fund strategies. The fund-ofhedge-funds (FoHF) model, however, continues to experience headwinds. Performance dispersion across hedge fund strategies remains significant, and while 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 overinflated *Sources: HFI, Barclays Capital, Preqin 2 towerswatson.com 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 book 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 information about the investments themselves. The issues we address include managed account structures, the development of alternative Undertaking for Collective Investment in Transferable Securities (UCITS) funds, shifts in the fee model and the growth of more efficient alternatives to certain hedge fund exposures. We thank you for your participation in our ongoing dialogue about these and other issues, and hope you find this book useful in your deliberations over the place of hedge funds in your organization’s portfolio. We welcome your feedback and comments. Managed Accounts: An Evolution Introduction Our last hedge fund book* outlined the characteristics of the managed account market, including the reasons for investor interest, and the advantages and disadvantages we believed managed accounts and associated platforms could provide. Managed account solutions continue to evolve, with the introduction of new platform providers and services offered. This thought piece discusses the evolution that has occurred and how it has altered the options available to hedge fund investors. A Quick Refresher Managed accounts, also referred to as separate accounts, can be set up by individual clients or accessed through a managed account platform (MAP) provider, and can reduce the operational and administrative burden to the investor. Depending on the platform and account type, assets may be comingled with those of other MAP investors. Historically, our view on managed accounts and MAPs has been that they provided a solution for a subset of investors, but that for the main part, the potential disadvantages outweighed the advantages, particularly for long-term institutional investors. Managed accounts and MAPs offered benefits such as greater transparency and scrutiny of manager trading activity, improved governance of investment guidelines and liquidity. However, they also placed additional operational burdens on the hedge fund manager (e.g., the need to split trades, use of different counterparties and possible alternative investment guidelines) and, consequently, were often deemed an unattractive way to manage assets compared with the traditional pooled fund approach. As a result, we felt managed accounts and MAPs were subject to adverse selection, with a bias toward managers either intent on raising assets or those struggling to do so, accepting the need to tackle the greater operational burden. In addition, longerterm institutional investors often did not require the additional liquidity provided by managed accounts. Often, with less liquid asset classes, the platform account differed significantly from the underlying hedge fund strategy and wasn’t focused on the core skill set of the manager (e.g., liquid credit carve-outs from event-driven or distressed credit managers). Our concerns made us cautious about whether institutional investors would receive sufficient additional benefits to justify the costs associated with managed accounts or MAPs. “Managed “ account solutions continue to evolve, with the introduction of new platform providers and services offered.” Evolution and Rise of the Managed Fund The MAP market is evolving. Many of the established players in this space were early movers into comingled managed account services, which were designed to offer investors a differentiated fund-offund model (i.e., a choice of approved, comingled accounts from the MAP with enhanced liquidity and transparency). However, recently, increased interest from large, sophisticated institutional investors has grown the demand for greater customization and segregated, rather than comingled, mandates. In response, a number of new MAP providers have entered the market, some of which specialize solely in these customizable, segregated services. At the same time, the established players have expanded their service packages to also include a customizable, segregated service. As a result, the MAP market is now more competitive and has a new product offering, a managed fund.** *Hedge Fund Investing: Opportunities and Challenges **For lack of a better, standardized term for this product (segregated fund structure run by an independent third party), this is what we shall use throughout the remainder of the piece. The Hedge Fund Landscape: Our Latest Thinking 3 At this point, it is worth defining the key differences between managed accounts (separate accounts), managed funds and the other alternative to investors, the fund of one. A summary of the key differences is illustrated in the sidebar (page 5). A managed account is held at the investor’s custodian, and an investment management agreement (IMA) is drawn up by the investor to delegate the investment management of the account to the manager. Importantly, the investor retains ownership of the account and the assets within it, and is responsible for negotiating the required International Swaps and Derivatives Association (ISDA) with trading counterparties. Comingled MAPs are different: The MAP, not the investor, is responsible for executing the IMA with the manager and monitoring the account. The assets remain segregated from the manager, but investors are pooled together into the same account. With a fund of one, investors are able to reduce some of the risks associated with investing in a pooled account or fund,* but may not benefit from many of the advantages a managed account can provide. A fund of one is a separate fund created by the manager solely for one investor. The terms of the fund of one are typically similar to that of the traditional pooled fund run by the manager, although they can differ by consent of both parties. Crucially, in such circumstances, the manager retains ownership of the vehicle and custody of the assets within it, and may (or may not) offer better transparency than pooled fund investors receive. The advantage of a fund of one is that it does not relinquish too much control or impose the same administrative burden as a managed account (counterparties being identical). It offers the advantage that managers that shy away from managed accounts may be more open to working with investors that require such structures, thus reducing adverse selection bias. A managed fund is fully customizable, and not only offers the investor many of the positive characteristics of a managed account, but also, if sensibly structured, can reduce the burden on managers and, therefore, also adverse selection bias. One simplified way to think of it is as a separately managed account wrapped in a fund structure. A separate fund is created by a MAP provider with delegation of the investment management of the fund to the manager. In such circumstances, the MAP provider offers its capabilities to set up and run a managed fund, but the investor, in negotiation with the manager, has full responsibility and discretion to dictate the fund structure (liquidity, investment guidelines, preferred counterparties and board of directors, among other points). The investor also retains full control over manager selection, rather than having to make a choice from a list provided by the MAP provider. The important element to note is that the managed fund is created and run by the independent MAP provider, with the investor owning shares in the fund. The managed fund is also governed by a board of directors that enforces the IMA. The structure offers two-way protection to the manager and investor: •• The manager is protected from investor actions outside of those agreed on in the IMA — in a traditional separate account, the client has ownership and custody of the assets, and could call for a liquidation of assets, possibly adversely impacting the prices of the same securities held in the vehicles operated by the manager. Further, the manager is protected from unanticipated withdrawals of capital (and the resulting business risk), as the managed fund has agreed-on liquidity terms, with the assets owned by the managed fund and not the investor. •• The investor also benefits from independent custody, valuation and oversight that include a formal fund board of directors. *Assuming a separate offshore vehicle is created “A “ managed fund is fully customizable, and not only offers the investor many of the positive characteristics of a managed account, but also, if sensibly structured, can reduce the burden on managers and, therefore, also adverse selection bias.” 4 towerswatson.com What This Means for Hedge Fund Investments With the emergence of the managed fund service, we recognize that a number of our reservations regarding MAPs may in theory have eased. In particular, the ability to dictate the structure of the managed fund enables the investor to more closely mimic the guidelines, structure and counterparties of the pooled hedge fund and, thus, make managing money in such a structure as painless as possible for the manager. In return, this, coupled with the ability of the investor to select the manager, should help alleviate some of the adverse selection bias that has historically concerned us with comingled platform accounts. It should be noted, however, that adverse selection will still persist, as in many cases, hedge fund managers are likely to resist the use of managed funds, particularly managers already at or near capacity. Furthermore, the ability to dictate the managed fund liquidity also empowers the investor to avoid a mismatch to the strategy and enables the manager to run the managed fund in line with its pooled fund and skill set. At the same time, with the transfer of responsibility of fund structure from the platform provider to the investor, the fees charged to access a customizable, managed fund solution are typically lower than through the traditional platformcomingled account approach. The reason for this is because the MAP provider serves to simply provide the infrastructure to a client that brings a hedge fund to it, instead of sponsoring the manager for inclusion on its platform and conducting its own due diligence. However, it should be noted that the theoretical benefits of a managed fund described above are reliant on the negotiation of terms between the investor and the fund manager, and the conclusion of a mutually agreeable and beneficial solution. An important element to reduce adverse selection bias is for managers to feel comfortable running such structures, and therefore, investors may need to compromise on certain powers typical of managed accounts (for example, instantaneous liquidity and termination power), which in practice have been skewed toward the investor. In conclusion, while we retain our view that managed accounts provide an optimal solution only for a subset of investors, we recognize that managed funds may provide a wider solution for investors and hedge fund managers. Such funds may help clients more appropriately address their unique needs with lower fees than are typically charged for accessing a comingled managed account and reduce adverse selection bias to some extent. That said, we still retain concerns that adverse selection will not be eliminated completely and that a traditional pooled fund may continue to be the optimal implementation method for many investors. Definitions Managed accounts •• Separate account at a client’s broker with delegation of the investment management of the fund to the manager •• Client owns the account and has control of the assets within it •• Requires the client to set up its own service providers and counterparty agreements (e.g., ISDA, custodian or administrator) or access through an account on a platform instead •• Provides increased transparency, independent oversight and liquidity (as the client owns the assets) •• Greater operational burden and client risk to managers results in fewer managers willing to offer this solution •• If accessed through a comingled MAP, access fees can be relatively high Customized managed fund •• Separate fund is created by a MAP provider with delegation of the investment management of the fund to the manager •• The fund owns the assets within it; the client owns shares within the fund •• The independent platform provider and board of directors of the fund provide oversight and enforcement of the fund guidelines (IMA) from both the manager and the client •• May provide enhanced transparency (negotiable with manager); does not necessarily provide better liquidity relative to the pooled fund •• Client and manager agree on the structure of the fund, which is fully customizable to address the preferences of the client and concerns of the manager •• Platform access fees are lower than under comingled managed account approach Fund of one •• Separate fund is created by the hedge fund manager solely for one investor •• Terms typically similar to that of the pooled fund run by the manager, although can differ by consent of the two parties •• Manager retains custody of the assets, and there is no independent oversight •• Segregation of investor from potential adverse behavior of coinvestors within the pooled vehicle (redemption pressures) The Hedge Fund Landscape: Our Latest Thinking 5 The Alternative UCITS Market The Power of Perception “UCITS “ regulations have progressed through a number of iterations, with rules generally updated in consultation with market participants, including the larger asset managers.” Introduction Background The alternative UCITS universe has sprung to life. What was historically an appealing investment option for individuals has attracted significant growth in assets over the past year, including from European institutional investors. The key benefits to investing in alternative UCITS-compliant funds are broadly considered to be: Reasons for this demand ranged from a broadly improved investment appetite to tax incentives, but were also due to investors seeking protection under regulatory authorization. We assess the factual details of these “safety” perceptions and present the realities that many investors are either ignoring or unaware of, paying special attention to fees, liquidity, transparency and regulatory oversight. We also consider the growth in the number of funds and question the suitability and attractiveness of strategies within the UCITS framework, as well as whether UCITS funds are set to overtake their offshore counterparts in Europe. •• Regulatory oversight •• Greater transparency offered than traditional hedge funds •• Frequent liquidity, typically daily or weekly dealing •• Low minimum investment thresholds •• Efficient tax treatment in some jurisdictions The UCITS directives aim to subject open-ended EU-domiciled funds investing in transferable securities to the same regulation in every member state, promoting consistency across the industry. This regulation has applied to long-only mutual funds since 1985 but is now also applicable to hedge funds that wish to register. UCITS regulations have progressed through a number of iterations, with rules generally updated in consultation with market participants, including the larger asset managers. Key Points •• By the end of 2013, the alternatives UCITS universe stood at €160 billion — over 20% growth for the year. •• In the past year, institutions have become the largest investors, mostly due to solvency and regulatory requirements, as well as tax incentives. •• Private banks and retail distributors remain significant allocators. •• A greater range of strategies is available with a deeper pool of talent, particularly from the U.S. •• Continual evolution of regulations have occurred in the space, but oversight measures are light in some cases. •• We prefer managers to keep to their core skill set and consider if they are sacrificing their true edge when fitting a product into a UCITS framework. 6 towerswatson.com •• A number of funds have already reached capacity and are closing to further subscriptions. •• There is a broader range of fee structures than was previously available. •• Performance fee structures are suboptimal in most UCITS funds and are not being given sufficient consideration by investors. •• Investor perception of liquidity could pose the greatest risk, with most funds having the ability to gate. •• UCITS investing does not directly help in achieving Solvency II requirements. •• Deep manager research remains key to assessing the quality of the strategy implementation, as relying on a wellintentioned regulator’s stamp of approval is not sufficient in protecting capital. The current UCITS IV directive imposes the requirement for a new Key Investor Information Document, which discloses risks and investment objectives in clear language. Versions V and VI are on their way, with the focus on depositary liability and eligible assets. Further regulation is also imposed by the European Securities and Markets Authority guidelines. Statistics The UCITS universe stood at €159.4 billion at the end of 2013, having grown €25 billion over the year, or 21%, according to Kepler Partners LLP.* Other databases quote values up to €220 billion. Some of the increase can be attributed to performance (averaging around 6% to 8% return), but the majority reflect inflows in investor capital. With regard to how many alternative UCITS funds these assets are allocated to, various surveys indicate a range of 600 to 800 existing today. It should be noted that the asset base is still somewhat concentrated at the top end of the asset management spectrum by size, with single funds managed by four managers currently representing €50 billion. Also very important for hedge funds is the Alternative Investment Fund Managers Directive (AIFMD) regulation, which became effective July 2013. (Note that the AIFMD is focused on investment managers, while UCITS is aimed at the fund level.) There are a number of significant considerations for managers, but the one of most concern to us here, compared to UCITS funds, is the marketing ability in Europe. The AIFMD stipulates that investment decisions need to be made within the European Economic Area. This can be challenging for non-European-based investment managers that do not want to shift key personnel to the continent from major financial centers such as New York. The UCITS route allows them to launch a fund, usually domiciled in Luxembourg or Ireland, that is then able to be “passported” to various European jurisdictions. * Annual Review: UCITS Review of 2013; English pound converted to euros within the space, the trend has been that assets in offshore funds have been stable over the past couple years, while assets in UCITS funds have risen rapidly and become a meaningful part of the market, almost equaling assets from offshore funds. Prior to 2013, the UCITS market was dominated by discretionary high-net-worth and retail allocators, particularly in the U.K. and Germany, where UCITS returns were taxed more favorably than in offshore products. Now, for many funds and platforms, the list of largest investors has been completely refreshed to continental European corporations and pension funds. The hedge fund industry has been improving since 2008 and, very recently, assets in European hedge funds have returned to their 2007 peak, according to Eurekahedge. However, taking a closer look 450 250 400 200 350 150 300 100 250 50 200 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 AuM (USD billions) AuM (USD billions) Figure 1. Comparison of assets in UCITS and non-UCITS European hedge funds since 2006 0 Non-UCITS funds (LHS) UCITS III European hedge funds (RHS) Source: Eurekahedge Note: Eurekahedge defines European hedge funds as managers with European head offices as well as non-European-based managers with European mandates. The Hedge Fund Landscape: Our Latest Thinking 7 UCITS Development: Supply, Demand and the Future The Three Waves of Supply A number of UCITS vehicles were eagerly launched between 2006 and 2008. Many of these were introduced by the larger European asset managers that were seeking to access more retail-oriented European clients. A pause ensued as the credit crisis and subsequent redemptions hit the fund industry, with managers taking time to recover their losses and waiting for a more stable environment to launch funds. In 2010, the first draft of the AIFM Directive was released, and U.S. managers in particular were faced with the possibility of being blocked from accessing the European capital base. Consequently, a number of larger U.S. players entered the market by launching UCITS funds. Meanwhile in Europe, many newly established equity managers were launching their debut funds as UCITS products. There was another quiet period in new UCITS launches until more recently, in 2013, when a number of factors again accelerated the launch of UCITS funds. New factors were: •• Substantial assets being raised in the UCITS universe, which proved that real demand existed and UCITS was no longer just a promised opportunity •• The growth of 40 Act alternative funds made U.S. hedge funds much more familiar, with highly liquid offerings •• These vehicles have been considered a practical alternative, since UCITS funds are outside the scope of AIFMD rules These factors allowed for a significant number of UCITS-compliant fund launches, not just in Europe but also from U.S.-based groups, and with a much greater breadth of managers. The UCITS universe was once criticized for being filled by mostly mediocre managers, but that is changing with what are regarded as higher-quality managers entering the space. Heightening Investor Interest The rapid rise of UCITS assets in 2013 has continued into 2014, with growth still coming from continental European private clients and increasingly from large institutional investors, particularly in the second quarter of 2013. To illustrate the scale of interest, many UCITS funds were closed to further subscriptions in 2013 and early 2014, as they had grown to full capacity, with many at US$1 billion to US$2 billion in assets under management. Moreover, two platforms have reportedly raised over US$2 billion in a matter of weeks for two funds this year, one of which was a new launch. In some cases, UCITS funds have grown larger than their related offshore funds. Some of the reasons for the heightened interest in the institutional world are tax structures and regulatory/solvency requirements, for example: •• In Germany, new capital gains taxes implemented at the end of 2013 made UCITS investing more attractive. •• In Spain, aside from lower tax rates when investing in UCITS versus offshore funds, investors are encouraged to keep reinvesting within UCITS products, paying taxes only when fully redeeming. “The “ UCITS universe was once criticized for being filled by mostly mediocre managers, but that is changing with what are regarded as higher-quality managers entering the space.” 8 towerswatson.com •• In Italy, the tax rate of investing in offshore products was recently raised. •• Tax transparency is offered by UCITS funds in a number of jurisdictions, such as the U.K. and Germany. •• In some countries, including Italy and Spain, insurance companies and pension funds have caps on how much exposure they can have to nonharmonized alternative funds (which include offshore, non-UCITS hedge funds) and are effectively encouraged to invest in UCITS funds. •• In some countries, insurance companies have managed to circumvent their capital charge limitations by investing in more liquid instruments and vehicles, which UCITS can satisfy. •• In the dominant high-net-worth market, platforms in some countries, such as Germany and Italy, demand daily liquidity, and UCITS have become popular investment vehicles. Other reasons can relate to behavioral aspects. For instance, discretionary managers and high-profile investors wishing to avoid situations of locked-up assets in illiquid holdings enjoy the comfort of a regulatory stamp to protect them against scrutiny, assured that their decisions were based on the belief that the funds are subject to higher regulatory oversight. Even non-European investors, particularly in Asia, South America and Canada, have been attracted to the regulated nature of UCITS funds. Other aspects include the political influences in Europe, as the spotlight continues to shine on hedge funds, as well as greater awareness of environmental and social governance in investing. “From “ an investment perspective, a considerable number of private banks and wealth managers have moved capital from long-only to long/short strategies, finding the current environment to be more favorable to this type of investing and looking to execute through UCITS.” Another significant reason for increased assets is the broadly improved market sentiment and investor appetite for alternative funds in general, which is not necessarily a UCITS-specific phenomenon. From an investment perspective, a considerable number of private banks and wealth managers have moved capital from long-only to long/short strategies, finding the current environment to be more favorable to this type of investing and looking to execute through UCITS. Similarly, there has been a move by European institutional investors to reallocate their hedge fund exposures to more liquid investments via UCITS. The Hedge Fund Landscape: Our Latest Thinking 9 The popular equity long/short strategy in 2013 was accessed by many investors (that could also invest offshore) through UCITS structures — indeed, assets have doubled in equity long/short over the past year. An observation by managers has been the positive behavior of relatively subdued flows from individual investors; that is, they are not subscribing in, and redeeming out of, funds on a daily/weekly basis, but holding onto investments for a longer duration. It should be highlighted that while some demand for UCITS funds has been regulatory-driven, the opposite has also been true where greater solvency requirements have led to redemptions. Will All Managers Launch UCITS Funds? What About AIFMD-Compliant and U.S. 40 Act Funds? UCITS is not a trend that all hedge fund managers will follow. First, the strategy must fit within the required framework. Second, it depends on how much the manager wants to attract European investors. Offshore fund providers argue that many of the advantages of UCITS funds are also now the norm in offshore funds. For instance, the appointment of independent service providers, as well as improved transparency and corporate governance, are at the forefront of operations. Regulators in jurisdictions such as the Cayman Islands have also tightened their grip, requiring more detailed and timely reporting. Therefore, there is the argument that operational and investment risks have somewhat reduced (or at least been addressed) in offshore vehicles. 10 towerswatson.com Funds with AIFMD status could appear to be a competitor for UCITS for being a route to market in Europe, although the overlap would only be if a fund strategy is eligible for UCITS. Two aspects a manager must consider when deciding which route to opt for are: •• The currently easier registration of UCITS and lighter demands on the investment manager from a business operations perspective •• The unconstrained investment mandate allowance of AIFMD, since there are no leverage, concentration and instrument-type restrictions with AIFMD Many of the rules with regard to service providers and fiduciary duties will be similar for AIFMD and the new UCITS rules. In the U.S., a parallel trend taking place is the notable growth of 40 Act alternative funds in the past year from both an asset and a number of offering perspectives, albeit from a lower base. These are alternative funds that can be packaged within the format of a mutual fund, largely targeted for the U.S. retail market. These products do not generally reflect the more sophisticated hedge funds they are derived from, unlike alternative UCITS funds. This is because of the high-liquidity requirement (daily redemptions) and because of the lack of a performance fee in most cases, which means that managers are less inclined to offer the same level of return target (or performance engine). The UCITS and 40 Act phenomena have recently merged in the form of a new opportunity for platforms and asset managers to offer a new breed of multi-manager products. These are UCITScompliant funds that allocate “sleeves” to external investment managers that sub-advise on managed accounts. Given the multi-managed account structure, the flexibility of these products is low relative to, for example, fund of funds, since it takes time to set up managed accounts, and in most cases, commitments are made to the managers for minimum asset levels. Nonetheless, the low cost, liquidity and risk aggregation ability (given the transparency into the managed accounts) will no doubt be appealing to some investors, and we expect there to be product proliferation in this space. “UCITS “ is not a trend that all hedge fund managers will follow. First, the strategy must fit within the required framework. Second, it depends on how much the manager wants to attract European investors.” The Hedge Fund Landscape: Our Latest Thinking 11 UCITS Strategies and the Importance of Manager Research “We “ believe that deep manager research remains imperative to assessing the quality of the strategy implementation, beyond the simple reliance on the regulatory stamp.” Over the past six years, the market has become more educated; managers are more practiced in managing a portfolio within the UCITS framework, and investors have become more comfortable with the strategies and returns relative to offshore vehicles. A corollary to a growing number of funds has been a greater number of strategies being represented. UCITS platforms have commented on their strong pipeline of high-quality managers with funds due to be launched in 2014, across a range of strategies. Nonetheless, one must be wary of the proliferation of new launches, which may test the robustness of the UCITS framework. We have been mindful of the following when comparing UCITS funds to unconstrained offshore vehicles: •• We have a preference for managers to stick to their core skill set. Has the edge of the manager been lost in excluding elements to meet the UCITS rules? This is most pertinent to macro, managed futures and credit managers, among others. •• If there is a tracking error in the performance of the two vehicles, can the manager truly blame the framework restrictions, or is there an allocation policy issue? Does the mindset of the manager, used to more unconstrained investing, mean that the offshore vehicles are preferred over UCITS? This tends to be an issue with multistrategy and event-driven funds. •• How liquid is the segment of the universe traded during crises, and how abnormal is the behavior of asset classes and sectors within this space? For instance, in 2008, contrary to expectation, shortdated Investment Grade Developed Market bonds were the least liquid across the developed market spectrum, as they were the most leveraged and were heavily sold. •• How much leverage is embedded in the derivatives used to execute the short exposure (for example, in CFDs and swaps)? •• Are tight risk management controls in place to avoid UCITS rule breaches and rapid de-risking? We are also increasingly seeing unconstrained portfolios being offered in a UCITS format via portfolio-level swaps. We are cautious of the extent to which some of these are adhering to the spirit of UCITS regulation, where the implied intent is to sidestep the rules. We believe that deep manager research remains imperative to assessing the quality of the strategy implementation, beyond the simple reliance on the regulatory stamp. High-Level UCITS Investment Rules Below are a few of the investment restrictions enforced on UCITS funds that do not apply to offshore funds. •• Ability to invest in defined eligible assets — in the case of long/short strategies, the strategy manager would purchase market-listed investments for the long portion of the portfolio, but physical shorting must be avoided, so shorts can be achieved through buying CFDs, swaps or options •• Concentration limits •• Leverage limits •• Value-at-risk (VaR) limits •• There are further rules on the allowed net exposure and counterparty risk exposure •• Investment in non-eligible assets (for example, commodities, property and private equity) is generally not permitted, but exposure can be gained through derivatives, and there are rules regarding implementation through swaps and valuation policies Note that funds can opt for different sets of risk reporting rules depending on their risk profile (the sophistication of the instruments employed). 12 towerswatson.com Figure 2. Our views on individual strategies Strategy UCITS suitability Equity long/short •• Most natural fit for the liquidity and instrument-type restrictions of the framework, as long as the portfolios meet the UCITS-imposed concentration levels •• Dominates the space: 30% to 40% of the UCITS universe by number of funds •• Broad selection in European space and increasingly in U.S. •• Track records show there is very little tracking error between unconstrained offshore equity funds and their mirrored UCITS versions Event-driven •• Usually liquid portfolio, but concentration levels can be limiting •• Tend to be equity-heavy portfolios •• Investment terms should match the investment horizon as much as possible •• Unsuitable for activist-type strategies, which would suffer from a potentially unstable capital base Credit •• Simple liquid corporate credit is suitable; both developed market investment grade and high yield •• Many non-vanilla instruments are either too complex or too illiquid for UCITS rules •• UCITS VaR limits are not restrictive (highly unlikely for the portfolios to reach the levels stipulated) •• Structured credit is unsuitable; distressed is largely not suitable (on liquidity grounds) •• One danger of credit is the nonlinear nature of liquidity in the markets — liquidity is based on demand and not on the size or term of the bond Macro •• Choices are limited in the space •• Most liquid instruments with low leverage can fit the framework •• Interest rates and FX are the most likely candidates •• Concentration levels can be a limitation •• Complex derivatives are unsuitable •• Cannot trade commodity futures •• May miss the trade structuring skill of managers as a result •• Poor recent performance of traditional macro funds has dampened demand Managed futures (CTA) •• CTA strategies have been limited due to the inability to trade commodity futures •• Funds and platforms have devised various ways to replicate CTAs into UCITS models, but few have been successful •• Increasing UCITS regulatory scrutiny is likely to cause a move to AIFMD registration Multistrategy •• Liquidity, concentration and instrument constraints •• Tend to be mostly equity portfolios with an ability to invest in other instruments in a limited manner •• UCITS versions of unconstrained multistrategy funds have usually removed some of the less liquid credit exposure and reduced position sizes of concentrated holdings •• Difficulty to ascertain the effectiveness of the allocation policy with regard to managing an unrestricted offshore product alongside a UCITS product, also difficult to assess the flexibility afforded by the differences in the portfolio in treating the products with a different mindset (performance drags can always be blamed on framework restrictions) Smart beta •• Very liquid portfolios with mostly daily-dealing funds •• Combining strategies that are not widely available from traditional UCITS products such as reinsurance, momentum and currency carry Multi-asset •• Liquid portfolios •• Illiquid (unlisted) asset classes unsuitable •• Limitations on investing in other funds Risk parity •• Liquid portfolios, mostly passive futures strategies •• Leverage and commodity futures restrictions apply The Hedge Fund Landscape: Our Latest Thinking 13 Common Perceptions of UCITS Funds Lower-Quality Product “The “ recent growth in managers electing to offer UCITS products has broadened investor choice, potentially increasing the quality of some available options.” Some strategies do not, and should not, fit the UCITS model, and those that are being forced into such structures result in suboptimal outcomes. The recent growth in managers electing to offer UCITS products has broadened investor choice, potentially increasing the quality of some available options. The view that some UCITS products are lower quality may be drawn from their inferior returns, which may be a result of higher costs and fees. We seek to understand the manager’s true skill and if it is able to be translated into UCITS. Highly Regulated UCITS regulations continue to be updated as lessons in implementation are learned along the way. Regulators assess funds in detail before allowing them to obtain their UCITS licenses. Detailed explanations and justifications of fund investment policies are demanded, and the registration process can be drawn out (usually taking much longer than for most offshore jurisdictions). Once set up and in motion, UCITS funds report their positions to the relevant regulators semiannually via their auditors. Leverage is also reported. The regulator has the power to fine and charge the investment managers if any significant deviations or breaches occur. We recognize that there are some shortfalls with the regulatory framework. The portfolios presented are snapshots on a lagged basis, and are therefore less relevant and perhaps misrepresentative of the typical profile. They also show actual holdings and not economic exposures, so some factors can be hidden, for instance, by the use of swaps. In terms of adhering to rules on an ongoing basis, these can be breached passively or actively. For example, a passive breach may occur if a stock price rises rapidly, meaning that a fund exceeds the concentration limit. In this case, the regulator is satisfied by timely reporting of the issue and rectification within a matter of days. An active breach is more serious and must be rectified by the fund immediately, refunding the investors of any expense incurred and informing the regulator through the auditor. While there is a possibility that a manager could hide this, the independent administrator custodian would be able to flag the issue to the regulator under their responsibilities within the relevant jurisdictions. Can UCITS Funds Help to Address Solvency II Requirements? UCITS funds can address Solvency I requirements, but Solvency II can be more difficult, as the regulation requires transparency through to the underlying positions and loss limitation. (Some managers will provide snapshots of portfolios with a lag, while others provide no transparency.) For clients seeking full transparency, the most effective means of investing in hedge funds remains through managed accounts, but this is not a path generally open for small allocations. Another route for adherence is through the application of swaps, notes or other derivatives around the fund products that currently meet regulatory approval, although the experience with those instruments in 2008 remains a significant hurdle for some investors. 14 towerswatson.com Highly Liquid Liquidity is possibly the greatest danger of UCITS funds. The actual liquidity of the funds may be tested in an extreme market shock. Daily and weekly dealing funds will be a challenge for investors placing redemptions at arguably the worst time to be liquidating a portfolio. This measure is not required to be regularly reported but could potentially be a problem in the future. A strategy particularly prone to a liquidity drift is credit, where managers could creep into instruments that become less liquid. This would not be picked up until the audit and requires close monitoring. A feature that many investors do not concentrate on is the ability for UCITS funds to gate and suspend redemptions, a concept prevalent in offshore hedge funds but in this case taken from the long-only UCITS practices. Gates usually range from 5% to 30% at the fund level (as opposed to investor level). However, depending on the jurisdiction, there are generally limits on how long the fund can suspend redemptions — usually two or three dealing dates. UCITS rules do require that portfolios are managed to meet reasonable redemptions. While this is a rule, the interpretation of “reasonable” can be relatively wide. Side-pocketing is also not explicitly ruled out in UCITS directives. High Transparency The Key Investor Information Document required of funds certainly aids in highlighting risks that may be borne by an investor in a more simplified format. Given the liquid nature of UCITS portfolios, managers are broadly willing to provide transparency on their entire portfolios, but not necessarily any more so than offshore managers, particularly given pronounced investor demands post-2008. When a manager runs a UCITS fund alongside a similar offshore product, it would be mindful of treating investors fairly, so again, transparency is not necessarily enhanced in the UCITS format. Clearly, less liquid strategies or those where there is limited transparency during certain periods (such as when building large positions in activism) would not be eligible for UCITS due to the instruments and concentration levels employed. From that standpoint, the UCITS rules filter out the less transparent strategies, but do not necessarily offer better transparency in the universe that remains. “A “ feature that many investors do not concentrate on is the ability for UCITS funds to gate and suspend redemptions, a concept prevalent in offshore hedge funds but in this case being taken from the long-only UCITS practices.” The Hedge Fund Landscape: Our Latest Thinking 15 Fees UCITS institutional share classes tend to charge management fees comprised of a 1% to 2% base fee and a 0% to 20% participation rate, with the terms evenly distributed across these ranges. There are a number of additional cost considerations when comparing UCITS funds to relevant offshore hedge funds. The most significant additional expenses in UCITS funds relate to administrative and statutory services: •• Fund accounting, custody and transfer agency costs can be comparable to offshore funds, particularly at larger asset levels, but at lower levels, can generally be 20 bps to 25 bps higher per annum due to the greater frequency of operations such as portfolio valuations and cash transfers. •• Statutory/cross-border costs can be significant legal and tax burdens (which are not incurred by offshore hedge funds since they are sold on private placements). These can amount to an extra 15 bps to 20 bps. •• Where relevant, local jurisdiction transaction taxes (for example, in Luxembourg) can also be significant. The above three are included within a total expense ratio calculation, which also takes account of base fees. Platforms and providers have different revenue streams, but usually their distribution fees are taken out of the management fee, and while not disclosed to investors, can be 60 bps to 100 bps. Platforms may also charge for other structuring offerings, such as additional portfolio swaps. Beyond the above factors, managers and investors have to consider whether greater liquidity and greater regulatory oversight would warrant higher fees for UCITS investors. There has been a significant shift in the viewpoints, from certainly higher fees a few years ago to a much wider perspective today. Some of the arguments, related to offshore structures are presented below. “UCITS funds should charge more” •• Charges are calculated in order to not penalize offshore investors that are tied in for longer to avoid cannibalizing offshore funds. •• There has been evidence of disgruntled investors redeeming from offshore products where UCITS funds have equivalent fees, but this is not as common as might be expected. “UCITS funds should charge the same” •• One UCITS platform recently publicly announced it did not believe investors should pay more for liquidity if the portfolio can adhere to daily or weekly dealing, and if the vehicles with different liquidity are separated. •• Managers prefer to have a UCITS product in order to protect themselves against losing European investors, rather than worry about cannibalization. “UCITS funds should charge less” •• In the case where the strategy has been watered down, for instance, with a lower leverage or narrower remit, this strategy adaptation has been used either where the full portfolio is not UCITScompliant or to justify a need for different fees. “Beyond “ the above factors, managers and investors have to consider whether greater liquidity and greater regulatory oversight would warrant higher fees for UCITS investors.” 16 towerswatson.com So, while in the past, UCITS funds tended to be more expensive, warding off many fee-sensitive institutional investors, offerings are changing as managers recognize the need to attract larger European-based investors. Examples of options tendered beyond institutional share classes include: Understanding the impact of performance fees on UCITS funds is important, and while solutions for fair calculations can be administratively burdensome where the number of investors are high and flows are very frequent, some attention needs to be taken in this area. •• Lower-fee, early-bird share classes for a limited capacity in new launches •• Step-down management fees as assets rise •• Rebates through side letters (these are permitted in UCITS, contrary to popular belief) •• Application of hurdle rates — at some point, the UCITS fund can become cheaper than the offshore •• Our view on fees remains guided by the impact on alpha share: Net of fees, we believe investors should be left with the bulk of alpha generated Further Fee Considerations Focus on Performance Fees Conclusion For completeness, we should also discuss one of the limitations of UCITS investing: The majority of UCITS funds accrue a performance fee at the shareclass level, rather than at the investor level. This means that an investor below its high-water mark may continue to pay performance fees, even though losses are being recovered. Various methodologies are prevalent in calculating the performance fee, some being performance across the average number of shares in issue, average performance across the full number of shares, or daily accrual including asset debits and credit. Other methods also exist, but none of the smoothing methods are perfect, and net asset values are in some way or another impacted by asset inflows and outflows. In some cases, these can work in favor of the manager and, other times, the investor (for instance, where investors can avoid paying any performance fees by trading in and out of a fund as it attains its blended high-water mark). Hedge fundlike series accounting or equalization principles are also not applied to UCITS funds, largely due to their previously retail nature. Nonetheless, this has not been an area where investors have spent much time. In many ways, UCITS directives have promoted processes and principles that have considerably improved practices in the hedge fund industry, iteratively improving the governance to address real investor issues. As such, the UCITS market has sprung to life and is likely to grow further, with the impression of safety being increasingly alluring for certain regulators and institutional investors. In a world of heightening demand for protection, this framework seemingly fits all requirements. Some managers have applied swing pricing or antidilution levies to protect investors in the funds when there are notable subscriptions and redemptions, which add trading costs. It is important to consider how the managers are adjusting for these measures, as there is usually very little transparency around the methods employed, which can be quite punitive. Nonetheless, the practicalities of adhering have meant that divisions have occurred between actual UCITS fund propositions and what investors believe they are getting. As such, caution and pragmatism must be applied in transparency, liquidity and fee expectations. Regulators should also be aware of the realities of both framework limitations and of strong incentives to drive capital into a limited capacity space. We would emphasize the importance of deep manager research before selecting UCITS funds for investment, as we believe that reliance on a well-intentioned regulatory stamp alone is insufficient to protect capital. More recently, some funds and platforms have been looking to improve the issue. For example, some are crystallizing fees earlier than annually to prevent any “free rides.” However, quarterly and annual performance fees pose their own conflicts of alignment. A few managers have also been offering institutional investors zero-fee share classes with regular invoicing, which can be tailored. The Hedge Fund Landscape: Our Latest Thinking 17 Hedge Fund Fees: Toward a Fairer Deal A Changing Dynamic A. Types of Hedge Fund Fee Structure For a number of years, supply-and-demand dynamics worked in favor 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-favored nation clauses, which were originally designed to protect investors but became an excuse not to offer concessions. Hedge fund fees usually consist of: The events of 2008 and the subsequent pressures faced by many hedge funds led to a reevaluation of the value added by hedge funds and the way 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 sizable allocations 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 the combination of the hedge fund’s 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 financial crisis. We believe that both are equally important in achieving a structure that better aligns the interests of funds with investors. 18 towerswatson.com •• An annual management fee •• A performance, or incentive, fee We believe structures that are well aligned should include: •• Management fees that properly reflect the position of the business •• Appropriate hurdle rates •• Non-resetting high-water marks (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 analyzing 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% to 40% of this alpha being paid to the manager. Annual management fees The management fee — often set at 2% of assets — provides the manager with revenue to cover the operating costs of the firm. In some large funds, the management fees may form a significant part of the manager’s profit. We would prefer to see annual management fees aligned with the operating costs of the firm, leaving the performance fee for employee bonuses. Over the past few years, we have seen a material reduction in the management fees our clients pay, resulting from both direct negotiations with hedge fund managers as well as the inclusion of alternative beta solutions in our client portfolios. We would ideally prefer to see tiered management fee structures (on a sliding scale), given that a firm’s operating costs do not normally increase in line with assets under management. We do, however, recognize that there are some strategies where alpha generation is reliant on growth in research resources or significant ongoing technology investments. Performance, or incentive, fees Performance fees are usually calculated as a percentage of the fund’s profits 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 sufficiently align manager and investor interests — managers share profits, 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-water marks 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 signifies that a manager will not charge a performance fee until performance exceeds a predetermined target. Using a hurdle encourages a hedge fund manager to provide a higher return than a traditional — usually lowerrisk — 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 reflect the level of net market exposure of the fund, although in practical terms, this is sometimes difficult to implement. A hurdle based on a risk-free rate can be more workable. High-water marks A high-water mark 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 modified high-water marks such as an amortizing high-water mark, 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-water mark, any losses are erased after a defined period of time has elapsed, meaning managers can charge fees again before reaching the previous peak value. We prefer the use of traditional non-resetting highwater marks 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 manager’s business. This could lead to difficulties in retaining talented investment professionals, and create an incentive to close the fund and simply start another one. A well-structured, modified high-water mark 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. “A “ well-structured, modified high-water mark provides managers with the resources to reward their best-performing staff and enable them to stay in business.” 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 manager’s favor. Consider a situation where the performance fee is calculated and paid quarterly: If the manager delivers a strong first quarter and three subsequent periods of underperformance, the manager would still be paid a performance fee (at the end of the first 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 profiles of managers and investors during both positive and negative return periods. 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 five years) or at the end of a lockup period. The Hedge Fund Landscape: Our Latest Thinking 19 Negotiating fee discounts “Hedge “ funds historically have offered less transparency than traditional asset managers, principally to retain any perceived informational and analytical advantage.” 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 manager’s ability to execute its strategy effectively. In addition, if an investorspecific fee is meaningfully lower than that of other accounts, the manager’s 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 manager’s ability to retain key investment professionals. We believe that the terms offered by a hedge fund manager are of equal importance to fees in aligning the interests of the manager with the investor, as we examine in Figure 3. 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 fiduciary reporting requirements of institutional investors and their advisors. The majority of hedge funds will now enter into detailed discussions of the risks assumed and significant positions within a fund, yet 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 verification of holding and analysis of the portfolio risk: Exposure, sensitivities and underlying instruments used can all be tracked, and combinations of managers can be modeled. 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 Figure 3. Terms Strategy Manager 1 Multistrategy Fixed-income Manager 2 hedge fund Macro hedge Manager 3 fund Equity long/ Manager 4 short hedge fund 20 towerswatson.com InvestorEarly redemption level fees Liquidity gate Hurdle Terms Notice period Lockup period Original terms 45 days 2 years + 1 NA full quarter Annual No Negotiated 90 days terms 3 years hard NA 3 years Original terms 1 year soft 3% Negotiated 180 terms days 2 years hard Original terms Fee per annum High-water mark Base Performance No 1-year loss carry forward 2.0% 20% No 3-month T-bills Yes 1.5% 20% (back-ended) Quarterly 25% per quarter No Yes 2.0% 20% NA Quarterly 25% per quarter LIBOR 6% Yes cap 1.0% 15% 3 years hard lock NA Annual No No Yes 2.0% 20% Negotiated 90 days terms 3 years rolling soft lock 5% if redeemed on first anniversary + any differential with Annual the fee structure of the other share class No LIBOR Yes 1.5% 15% (back-ended) Original terms 30 days 1 year hard NA Quarterly NA NA Yes 1.5% 20% Negotiated 30 days terms 1 year soft 4% Quarterly NA NA Yes 1.0% 15% 90 days 90 days Liquidity Initial lock periods 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 reflects 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. 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. 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 “prisoner’s dilemma” of preemptive 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 they are not left with the most illiquid assets. However, a manager should first 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. Sidepocket 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 indefinite time periods, particularly if investors have expressed their desire to redeem. 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 individuals, and where the fund does not offer clients ready liquidity, we strongly favor 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 coinvestment levels or material changes in firm ownership. Such provisions might include early redemption rights that loosen lockup periods and waive investor fees, or grant investors voting rights. We believe the lock term should be reasonable and, critically, that past the lock expiry, liquidity terms are aligned with the portfolio of assets. Holdbacks Some funds return 100% of the proceeds from redemptions to investors within days of the redemption date. Others hold back 5% to 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 holdbacks, 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 holdbacks. “We “ believe that the fees and terms offered by a hedge fund manager are of equal importance in Active negotiation of fees and terms aligning the interests of 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 investors. Since the financial crisis, we have been actively involved in negotiating and designing appropriate structures for our clients. Additionally, to encourage transparency, our entire list of favored managers has been migrated onto a third-party risk management platform. the manager with the investors.” We remain mindful that the fee concessions offered by managers will often come at the cost of reduced liquidity (generally an initial lockup 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 significant 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 toward structures that better align the interests of investors and managers, and this has been crucial to the revival and growth of the industry. The Hedge Fund Landscape: Our Latest Thinking 21 Activism: Strategy Overview “The “ extent of activism can range from a longonly investment manager simply voting its shares at a company’s annual general meeting (proxy voting), through to a private equity manager taking control of companies to effect very direct change.” In activism, investors use their ownership stake to influence the way a company is managed. These investors address a wide range of aspects, including the choice of management in the underlying company or the policies they employ. The extent of activism can range from a long-only investment manager simply voting its shares at a company’s annual general meeting (proxy voting), through to a private equity manager taking control of companies to effect very direct change. There are varying degrees of activism in between that can be classified broadly into two groups: •• There are active managers — including long-only and hedge fund managers — whose investment in a company is driven primarily by a view on valuation rather than their intention to effect change per se. These managers will, from time to time, engage more actively with the management teams of companies they own in situations where they believe management is not maximizing value in some material way. Direct engagement with underlying companies is a secondary driver. •• There are active managers — very often structured as hedge funds — whose added value proposition is much more driven by an activist stance and where the investments they make will be heavily predicated on their view that they can successfully effect change that will increase returns to shareholders. Direct engagement with underlying companies is a primary driver. Here we focus mainly on the latter group of managers, as well as give our views on the prevailing opportunity set for the activist style of investment. 22 towerswatson.com Approaches to Engagement Activist shareholders use their stake in a company to apply pressure on that company’s management. The goals of activist shareholders range from financial (seeking the increase of shareholder value through changes in corporate policy, financing structure, cost cutting and so on) to nonfinancial (for example, disinvestment from particular countries, adoption of environmentally friendly policies and so on). There are various ways an activist investor can influence companies, such as engaging with company management directly, gaining representation on the company’s board of directors, publicity campaigns, proposing shareholder resolutions, discussions with large shareholders, litigation and proxy battles, or participation on remuneration/ nominating committees. The success of the approach will often be determined by how successfully the activist engages with management and the extent of the influence that can be brought to bear to make changes happen in practice. Also important is the content of any change and its likelihood of succeeding. Content can cover operational changes to the business (such as disposal of part of the business, with reinvestment elsewhere), improved cost management, financial changes (for example, to balance sheet composition) or communication (for instance, better communication of corporate strategy with the market). Activists will usually seek to identify an undervalued company through deep fundamental analysis, together with a detailed understanding of market dynamics, governance structures and operational capabilities. For this reason, it is common to observe a number of activist teams with a management consulting background and/or private equity or banking experience. Beyond this, the ability to engage with company management to share not only the assessment of why there is underperformance, but also to convince it to implement the required change, demands very specific skill sets, and it is here one typically sees the distinction between collaborative approaches and those that are more hostile and aggressive. It is the subtleties of the way activists engage, their reputational leverage and the credibility of their content that will distinguish successful activist investors. Approach Preference Towers Watson prefers the more collaborative form of activism, where the manager seeks to engage (often very robustly) with company management behind the scenes. Discussions are focused on the implementation of structural changes within a company to improve operating margins over time or that lead to a business structure that is better rationalized by the market, resulting in higher valuation multiples. Often the target companies are established franchises that have undergone a period of poor management and share price underperformance: As a result, the entry point itself will offer some element of downside protection. Typically, this style of activist is more income statement-focused on the views and methods of improving the operational efficiency of companies over time. This contrasts with more balance sheet-focused approaches that tend to rely more heavily on the use of leverage to generate return. Such approaches also tend to be more aggressive in style, involving activities such as the use of proxy fights, public discussions on a company or its management’s failings, and generally adopting a more adversarial relationship with company management. This carries the disadvantage that investors with the activist manager can be inferred to hold the same adversarial, and in some cases controversial, view of a particular company or its management. Irrespective of style, an activist is seeking to effect change in a company’s management with the end result of value accretion for all shareholders and/or subsequent repricing upward to reflect the improved structure. Whether the approach is hostile (proxy fights and replacement of boards) or friendly, the end goal is to unlock value. The duration of investment and opportunity can be a multiyear period with little recourse to interim liquidity, hence it is very important that an investor in an activist fund is satisfied that the activist offers sufficient demonstrable skill to justify an allocation. Further, activist hedge funds may have more restrictive liquidity provisions than their fundamental long/ short equity or long-only peers, since their underlying investments require a longer holding period due to the time it takes for them to work with company management to implement their plan. As large stakes in target companies are held, it should also be noted that exiting positions can have regulatory restrictions or execution challenges. We have observed that the more collaborative activist approaches seeking to work with, rather than against, incumbent management tend to have an easier route to effecting positive change, though by its very nature, activism is highly idiosyncratic and situation-specific. This idiosyncratic nature is also observed in exit routes from positions that can range anywhere from a simple share sale to an industry buyer, to divestment of underlying businesses and subsequent cash distribution, share repurchase or corporate structure change, particularly increased or special dividends. The fact that there is no one method of exit allows inherent flexibility to the strategy (levers to pull). Also, by investing in publicly listed securities, there is always recourse to selling at an established and identifiable market price. This latter option also applies to being patient in waiting for an entry price rather than being restricted to what is for sale, which is often quoted as an advantage over the private equity approach. “We “ have observed that the more collaborative activist approaches seeking to work with, rather than against, incumbent management tend to have an easier route to effecting positive change.” The Activist’s Ability to Effect Change The corporate governance landscape has changed over recent decades, with more focus on company management to increase returns to shareholders. This can be achieved in a number of ways depending on the business a company is involved in, its ability to earn greater returns via improved capital management or operational management, or indeed running the business with the focus on generating cash rather than growth and returning this cash to shareholders. We believe this greater focus on shareholder returns provides a tailwind to activism, as there is a greater awareness of management’s broader responsibilities, including shareholders and the media in general. This results in a greater openness to engagement around a particular shareholder’s viewpoint and changes that can be made to improve returns, particularly where this investor has a track record of adding value for all shareholders. The Hedge Fund Landscape: Our Latest Thinking 23 Of course, there will always be scope for genuine differences in views between investors and management. For example, one opportunity for difference might be over the time horizon. One investor could have the objective of effecting change within a company that will result in a near-term increase in share price and an opportunity to exit for a quick profit. These are often characterized in the more balance sheet-driven approaches. An alternative “buy and hold” shareholder may take a longer-term view, waiting for management to make decisions that will result in longer-term, better returns on capital. This tends to be a feature of the more operationally focused, income statementdriven approaches. Company management can react differently to the presence of an activist investor on its shareholder register. Some might view this as having a strategic consulting partner who has substantial experience, is effectively providing free beneficial advice, and whose interests are aligned with management and other shareholders. This contrasts with employing an investment bank or management consultant (at significant cost), which are arguably more incentivized to give advice that will maximize fees (such as making an acquisition). In practice, the initial reaction of company management is often far more defensive. The real nuance of an activist’s skills lies in the ability to persuade company management to be in the former camp and truly engage with the proposed value-enhancement views. This is where we believe the current environment is much more conducive to engagement than, say, 10 to 20 years ago. The personality and charisma of the activist investor is a more pronounced success factor as a result. Credibility and influence An attractive element to investors of activism is its simplicity and transparency. This belies the skills applied by an activist to effect change, often going no further than the confines of the boardroom. That only a few investment decisions are taken by an activist means the approach is highly pathdependent, in the sense that a successful company management interaction and investment outcome often lead to a positive reference point for the following investment. The culmination of this is a “rainmaker” reputation, where the market tends to react positively to an activist disclosing, actual or rumored, its involvement in a company. A number of activists seek to be the largest shareholder in a target company in order to have the greatest influence over change. An important feature that we have observed with successful activists has been their ability to influence other shareholders — often the large, passive managers — that invest alongside them such that, in aggregate, a significant influence on company management can be exerted over and above the activist’s own shareholding. (It is unusual for more than one activist to be involved in a firm, though there have been some recent examples.) In some cases, independent shareholder advisors have also had influence over the outcome of an activist’s investment. “The “ real nuance of an activist’s skills lies in the ability to persuade company management to be in the former camp and truly engage with the proposed value-enhancement views.” 24 towerswatson.com Size and capacity As with asset managers in general, activists range in size and capacity limitations from small to mid-cap specialists managing limited amounts, typically US$2 billion assets under management (AUM) or less, through to more than US$10 billion. Often the latter can target a larger company with more capital: We have observed that this has been one of the drivers of the more prevalent, recent introduction of relative performance fees, as this allows investors to allocate to activists as part of their (typically larger) equity rather than hedge fund allocation. The activist benefits from greater influence as a result of capital available for investment with company management, and both ultimately benefit from the prospective improved return on capital. An extension of this size argument can be seen in the use of coinvestments in specific situations to focus capital raising in high-conviction ideas. By definition, this requires a specific marketing effort by the manager. Other Considerations Portfolio profile, fees and liquidity Activism is rarely a quickly implemented strategy, and activist managers value stability in their asset base in order to have a solid footing with which to continue their engagement with their underlying companies. As a result, investors are often asked to commit to capital locks, with one-, three- and fiveyear periods (in some cases, rolling) common. Some managers will offer quarterly liquidity, although capacity in such share classes tends to be limited by managers and is subject to higher fees. Activist managers are generally bracketed as hedge funds but, in practice, make very limited, if any, use of leverage and limited to no use of short exposure. As such, both the gross and net exposure will vary close to 100%, akin to a long-only manager, although hedge fund fee structures are commonly applied: a base fee generally ranging from 1.5% to 2.5% and absolute performance fees of 15% to 20%. In these situations, we strongly prefer to see the performance fee calculated and paid at the end of the lock period so that this incentive is kept at risk during the period that investors cannot access their capital. We are seeing an increased adoption of relative performance fee structures. We view these positively, as they address the market beta element of a manager’s return profile. Portfolios are typically very concentrated: Five to 10 core positions are not uncommon, with a tail of smaller toehold positions that are fundamentally attractive, but where the engagement process with company management is at an earlier stage. As noted earlier, activists tend to make little use of shorting. Where this is applied, it is typically achieved through index exposure or broad baskets of securities as hedging around corresponding core positions. We would not ascribe a significant alphagenerative assumption to this blunt style of shorting — core long alpha is what is being accessed with an activist manager. Our return-driver approach to portfolio construction is more conducive to including the strategy since Towers Watson is able to work with clients to decouple component risk premiums, which are generally equity beta plus alpha, and then include them in their overall asset allocation by adjusting allocations with significant equity beta elsewhere. The significant equity beta of the strategy can create challenges for funds of hedge fund or dedicated hedge fund portfolio advisors where oversight of a broader asset allocation framework is not part of their mandate, as this equity beta often conflicts with typical return objectives. The advent of relative performance fee structures also supports the case for an allocation within a long-only active equity layer. Risk factors •• Concentration issues: Portfolios tend to be concentrated and highly idiosyncratic, meaning that there will be a “lumpy” return profile with single individual positions capable of causing significant decay in performance should there be obstacles encountered in the engagement process. •• Liquidity: What is the exit route? Given the size of the position and the public awareness of the position, is it easy to liquidate at a fair price? •• Related to this point, it is possible for an activist to be treated as an insider in a position, thereby restricting their ability to trade in certain windows, such as around earnings announcements. The Hedge Fund Landscape: Our Latest Thinking 25 •• The experience and expertise of the activist in the regulatory domiciles affecting its underlying investments, for example, local rules relating to how shareholders engage with each other — in other words, there is a risk of a group of large shareholders becoming a “concert partner,” when they can be forced to bid for a company. •• A high level of key man risk, given the specific nature of the engagement process and its transparency via public markets (positions being reported in quarterly Form 13F/13D submissions in the U.S., financial press and so forth): The latter can create headline risks that some investors are not comfortable being associated with. •• The associated risks of a failed attempt in a core position can have a potentially deleterious effect on a manager’s reputation and credibility for subsequent investments. Versus private equity, long-only, replication We note that activist managers operate within the public equity markets, with the transfer of positions to private ownership a relatively rare occurrence and, in a number of cases, prevented by fund documentation. As such, the activist investment teams are inherently reliant on imperfect information (relayed via public markets rather than as a private owner of a business), and they also have to implement their strategy in the full view of public markets, which can lead to near-term volatility of share prices as the market assimilates developments. A private equity manager has the benefit of being able to implement change away from this public forum. “By “ investing in public markets, activists can often overlap in positions with long-term ‘buy and hold’ long-only managers that can often benefit as a result of the work by activist managers.” 26 towerswatson.com A criticism leveled at private equity managers is that they can face a limited opportunity set, with the resultant risk that this can lead to overpaying, and in those instances, driving attractive returns becomes very difficult even with the full range of activist tools available. Comparatively, there may also be greater recourse to the use of leverage by some private equity managers than a more income statementfocused activist that is striving for a gradual improvement in company operating margins. It should be noted that not all private equity managers place a heavy reliance on leverage, and in a number of instances, they have a principal focus on adding value via operational and strategic improvement. The attraction of shareholder activism lies in its low capital requirement compared to similar approaches to unlocking value by private equity managers — that is, a fairly small stake (less than 10% of outstanding shares) may be enough to launch a successful campaign. In comparison, a full takeover bid is typically a much more costly and difficult undertaking. By investing in public markets, activists can often overlap in positions with long-term “buy and hold” long-only managers that can often benefit as a result of the work by activist managers. The advantage to an investor is that this is often achieved at a low fee rate (typically less than a 1% flat fee) and in a liquid comingled fund or managed account format. These managers, however, tend to run comparatively more diversified portfolios, so the benefit of this work is not quite as pronounced in return terms, plus the long-only manager is not in control of the engagement process with the company concerned. We view this as a key characteristic of activism. That said, with the requirement in the U.S. for asset managers over US$100 million to report their long equity holdings and for disclosure of stakes of over 5% of a firm by a fund with activist intentions (Form 13F/13D filings), this data source is increasingly mined as a source of activist alternative beta by index providers at comparatively lower fees and greater liquidity than offered directly by activist managers. By definition, these approaches are “coattail” and reactive, although the low-turnover nature of activist portfolios does lend itself to this type of approach, and if one can marry a lower alpha expectation to lower fees and improved liquidity, it becomes a potentially attractive portfolio allocation, principally as it can incorporate the views of a range of managers rather than one in particular. However, certain activist managers will be more successful than others, and so, indirectly, manager due diligence and selection remains an important ingredient to success. Further, a significant amount of value is often realized from the appreciation of a company’s stock when the news of an activist’s involvement becomes public. Investing based on lagged public filings would not capture this. What Would Constitute a Less Compelling Environment for Activism? There are some factors that we believe would make activism a less compelling investment approach. Some examples of these are as follows: •• Significant change in corporate governance/ regulatory environment impacting shareholder participation •• Evidence of persistent allocation to cash within a portfolio (signalling a weak opportunity set) •• Significant decline in corporate M&A activity •• Significant increase in market volatility — should the volatility persist, it could erode the willingness of companies to undertake many of the actions that activists suggest, as high-volatility regimes are often associated with company management uncertainty, increasing financing rates/spreads and a decrease in M&A activity What Does Towers Watson Look For in a Good Activist Manager? •• An investment team with company management experience, often management consultancy or private equity backgrounds •• Evidence through their detailed fundamental research of a strong knowledge of the underlying businesses in which they are invested and why their proposed value enhancement strategies make sense •• Demonstrable reasons why they will have the credibility to influence company management: Path dependency is important — prior success in investments and continued positive relationships with prior company management as well as other shareholders that often act as references •• Awareness of risks — selection of entry point is important •• Appropriate fund terms — a liquidity structure that supports the process as well as a fee structure that ideally addresses the often significant net market exposure Conclusion We believe that the backdrop for activist investing is benefiting from significant tailwinds, and that the strategy is one where manager alpha can be more tangible and identifiable than other hedge fund strategies. Investors do need to factor into their decision whether to invest the significant equity beta that is inherent in the strategy, as well as their ability to accommodate a level of illiquidity. However, the portfolio benefits of a highly active and concentrated approach can make a significant contribution at the aggregate portfolio level, be this either as part of a hedge fund allocation or broader equity long-only layer. The Hedge Fund Landscape: Our Latest Thinking 27 Improving the FoHF Model “The “ genesis of today’s issues dates back to the 1990s, when the hedge fund industry was much smaller and more opaque than it is today, and institutional investors started to consider hedge funds as a good addition to their portfolios.” Over the years, we have frequently discussed the flaws of FoHFs and continue to welcome discussion. While some of the best-in-class FoHFs recognized and addressed some of these flaws, the vast majority of offerings remain suboptimal. This is true of mainstream, diversified, multistrategy pooled FoHFs and even the separate accounts offered by some of these organizations. In addition, many pooled FoHFs that claim to be niche or specialist often still have the majority of their portfolios invested in relatively mainstream hedge fund strategies. The genesis of today’s issues dates back to the 1990s, when the hedge fund industry was much smaller and more opaque than it is today, and institutional investors started to consider hedge funds as a good addition to their portfolios. FoHFs were then created to offer preferential access to the alpha — the very best hedge funds could produce. At the time, the alpha produced by the wider hedge fund industry was also substantial because it had a first-mover advantage, and the industry was much smaller and dominated by truly skilled investment professionals. As the hedge fund industry has grown and matured, the majority of FoHFs have failed to adapt to reflect the new reality where they produce less alpha, and institutional investors have more ready access. Persistent weaknesses include: Poorly aligned fees. The absolute level of FoHF fees remains too high, on both a pooled and a separate account basis. Although fees have slowly declined, in our view, there is still a long way to go. The problem is that the FoHF industry has an inflated 28 towerswatson.com cost structure that can be supported only on the old fee model. It is clear that the new fee model is considerably lower, and in that scenario, most cannot survive. Performance fees should also be much better aligned with investors’ interests. In particular, they should be based only on true alpha creation, not total return. Most performance fees are not designed in this way and therefore actually encourage some misalignments (more so than a basic ad valorem fee). FoHFs should also consider ways to avoid assetgathering incentives over time, for example, by setting strict capacity levels in advance. High underlying manager fees. Through better negotiations with managers and, in particular, the use of well-designed hedge fund smart beta products, it should be possible to attain an average fee far lower than the typical fees found within even the best FoHFs. Of course, one should never choose a manager on the basis of fees alone: The net alpha (net of both fees and beta) is key. So FoHFs should make more use of fee-modeling tools and their relationships with underlying managers to ensure that the proportion of forward-looking true alpha being paid in fees is appropriate for each hedge fund as well as at the total FoHF level. Correlation. Correlation with equity and credit beta is generally higher in FoHFs than most institutional clients would like. Unless fee structures change radically, FoHFs should rarely include significantly net-long long/short equity and credit hedge funds, as most investors would be better served getting this exposure via their long-only managers. Of course, that is not something an FoHF can do, hence, correlation persists. Overdiversification. The number of managers in a portfolio should be more limited than is typically the case to ensure that it remains a focused fund while still running the appropriate risk levels. At the moment, most FoHFs are overdiversified and have stayed open too long, having not set limits on the number of funds and/or diversification at the outset. Asset/liability mismatch. Many FoHFs have historically offered greater liquidity to clients than they actually have in the underlying funds, which can cause huge problems if clients start redeeming at the same time. While many FoHFs have improved on this, they are still generally not very flexible on redemption. For example, dilution levies are unusual, and FoHFs do not typically make it possible to pay redeeming clients in units rather than cash where there are any remaining locks. Transparency and risk monitoring. Only the very best FoHFs get holdings-based risk analyses done on all of their underlying funds. More direct managers should put their portfolios on proprietary or established third-party platforms, allowing the production of a combined total portfolio risk analysis, which would be far more transparent. Change Is Needed A number of traditional FoHFs have transitioned into hedge fund solution providers, offering a range of services across customized, opportunistic and advisory-style mandates. This has introduced additional competition into the marketplace, which can only be a good thing for the end client. Others have looked to address some of the areas of concern, but most have not, and overall fees remain far too high. To put this in perspective, an institutional client investing in a typical FoHF achieving a net return of cash plus 5% per annum would likely be paying fees of close to 5% per annum. This is not acceptable. Change is needed. “A “ number of traditional FoHFs have transitioned into hedge fund solution providers, offering a range of services across customized, opportunistic and advisory-style mandates.” The Hedge Fund Landscape: Our Latest Thinking 29 Hedge Fund Portfolio Construction Key Considerations “It “ is paramount to have a dedicated and wellresourced hedge fund research team to conduct the bottom-up manager due diligence.” The process of constructing a hedge fund portfolio is both an art and a science. While the flexibility managers have allows them the possibility of generating alpha, it also means that selecting the appropriate managers necessitates expert analysis and judgment. Our goal in this section is to focus on hedge fund portfolio construction, with less of an emphasis on how to identify the best managers through due diligence.* Below, we discuss what we believe are several of the ingredients for success. Manager Universe A universe of high-conviction hedge funds across a variety of strategies is the starting point for any hedge fund portfolio. It is paramount to have a dedicated and well-resourced hedge fund research team to conduct the bottom-up manager due diligence. Our experience in building and managing portfolios for clients supports the belief that hedge fund manager selection insight comes only through primary research. In addition to investment due diligence, conducting operational due diligence prior to approving a manager may identify important risks. Operational due diligence is the part of the process where the hedge fund business is reviewed to assess whether the proper controls, resources and procedures are in place to adequately support investment and trading activities. Finally, an analysis of a hedge fund manager should include a review of the manager’s capacity (i.e., whether the manager with its management style is able to take in additional assets without impeding its ability to invest). Even region-specific constraints such as the ability of a manager to take ERISAclassified assets may need to be examined. Guidelines and Constraints The starting point for constructing a hedge fund portfolio from this universe of high-conviction managers is establishing appropriate investment guidelines and constraints. Often, these will be client-specific, expressing risk tolerances and preferences framed by overall portfolio objectives that typically include: •• Return and volatility targets. For example, a typical target return for a diversified hedge fund portfolio might be LIBOR + 4% to 6% annualized, with annualized volatility of 4% to 8%. •• Strategy allocations. Investors may want to limit their allocations to certain strategies or weight others higher. •• Exposure guidelines. Such guidelines are put in place to minimize the risk of capturing market exposures that are redundant with other parts of a portfolio. Often, investors are sensitive to equity, credit or other risk premiums across their asset allocation and look to hedge funds as a source of diversified returns. •• Liquidity guidelines. Investors will have different tolerances for liquidity and will typically express this with reference to proportions of the portfolio that either need to be realizable in a specified period of time, or a maximum proportion that can be locked up for a given period of time, or both. •• Maximum percentage allocations to any one manager to mitigate manager-specific risk. This can be based on a simple percentage of capital allocated or on the downside risk of the manager. •• Drawdown or stress period management. It is informative to see how the portfolio would have behaved in prior stress periods, as well as to make projections on how it could behave in future periods, making certain assumptions. *For additional content related to our views on hedge fund fees, terms, alpha assessment and other interesting topics, please reference our book: Hedge Fund Investing — Opportunities and Challenges, available at towerswatson.com. 30 towerswatson.com •• FX hedging policy and choice-of-fund share class. For instance, while most hedge funds offer U.S.-dollar share classes, for clients outside the U.S., it may be important to have a share class denominated in their home currencies. While these hedge fund portfolio constraints are fairly common, there are still many others that are possible. Diversity Versus Dilution There is a balance between achieving diversity in a hedge fund portfolio and having too many managers in the portfolio so that it dilutes any meaningful benefit from strong manager selection reflected in returns. We would argue that overdiversification (dilution) is one of the most common mistakes that investors make when building a hedge fund portfolio, adding complexity while debasing conviction. How prevalent is hedge-fund-of-fund dilution today? And what are the implications for investors? Today, most hedge funds of funds have 30 to 50 (or more) managers, resulting in alpha being diluted or diversified away, eroding opportunity for the investor. Consider Figure 4, which shows Towers Watson’s highest-rated hedge fund managers. It is clear that the reduction in risk by adding the next manager is indistinguishable well before reaching a 30-manager portfolio. There are other factors in addition to volatility reduction, such as the liquidity of the portfolio and achieving the right strategy allocation at a higher level, that have to be considered when justifying a higher manager count. But we would argue that a portfolio of more than 20 to 25 managers begins to look more like an index — making it increasingly difficult in our minds to justify high fees. Finally, the added complexity of a large manager lineup makes it more difficult to stay on top of each manager in the portfolio and creates governance challenges that are unnecessary if the portfolio is constructed appropriately. Complementary Strategy, Style and Manager Allocations Diversification across strategies and styles, and low pairwise correlations between managers should ideally lead to a portfolio that exhibits low volatility and beta while still generating alpha. A hypothetical portfolio will help us illustrate how powerful this diversification effect can be in a hedge fund portfolio. Importantly, the primary goals of this portfolio include low annualized volatility and low beta to equity markets. Where the client already has a significant public equity allocation, the ability of the portfolio to serve as a diversifier is just as important as its ability to generate returns. Strategy Allocations As illustrated in Figure 5, the portfolio is allocated across several broad strategies. It was built with a higher allocation to diversifying strategies such as macro and statistical arbitrage, which tend to exhibit less volatility and beta than more directional strategies such as equity long/short. A sizable allocation to “smart beta” managers was included — these funds are structured to capture many of the diversifying characteristics of hedge funds, but at a fraction of the cost.* Figure 4. Benefits of hedge fund manager diversification 16% 14% 12% Where additional managers have minimal impact in reducing volatility 10% 8% 6% 4% 2% 0% 0 10 20 30 40 50 Number of managers Figure 5. Strategy allocation for the hypothetical portfolio Proposed hedge fund strategy breakdown 11% 17% 11% 15% 9% 9% 11% 18% 17% Credit long/short 15% Equity long/ short directional 11% Multistrategy 18% Discretionary macro 9% Systematic macro 9% Smart beta — CTA 11% Smart beta — Reinsurance 11% Equity long/shortstatistical arbitrage *For more details on Towers Watson’s smart beta thoughts and capabilities, please contact your Towers Watson representative for a copy of Understanding Smart Beta, August 2013. The Hedge Fund Landscape: Our Latest Thinking 31 Manager Allocations and Relationships “While “ diverse strategy allocations are important, it is just as important to make sure that the underlying managers are generally uncorrelated in order to achieve the type of portfolio volatility profile (i.e., low volatility with downside protection) that most institutional clients demand.” equities based on a statistical approach that focuses on the relationship between securities over time and the propensity of the relationships to mean revert, and has a low correlation with each of the other equity long/short managers in the portfolio (0.0 and –0.1). Further, the manager maintains a book that is neutral to equity market beta and also exhibits a return profile that can be complementary (i.e., uncorrelated) with other strategies — for instance, the manager’s correlation with the overall portfolio is among the lowest, at 0.10. While diverse strategy allocations are important, it is just as important to make sure that the underlying managers are generally uncorrelated in order to achieve the type of portfolio volatility profile (i.e., low volatility with downside protection) that most institutional clients demand. One way is by allocating to managers that have different styles, even if they trade the same broad strategy classification. To illustrate, consider a few examples in Figure 6 and the references within. Macro-managers can deliver returns that are uncorrelated with major markets and often post positive returns during challenging market environments as other strategies suffer (e.g., many were positive in 2008). This diversifying element and the potential to offer downside protection were therefore important considerations in constructing the portfolio. In addition, the macro-allocation deliberately included three managers that had historically low pairwise correlations due to their style differences. Manager seven is discretionary and focuses almost entirely on trading Asian interest rate, foreign exchange and equity markets. Manager eight is also discretionary and focuses entirely on G7 interest rate trading. Finally, manager nine is systematic (i.e., rule-based and model-driven) and trades across a variety of markets and asset classes. While a core competency of each manager is to formulate macroeconomic views across countries and markets, and then express these views through investments, managers are still quite diversified by region, asset class and style. Managers one and two are each credit long/short managers. However, despite trading in the same markets (i.e., credit spreads and related securities), the correlation between the two is fairly low, at only 0.30. This is because they each have very different styles. Manager one is a bottom-up, fundamental manager that does deep analysis and research on individual companies, and also does a fair amount of investing in Asia. The other manager is tradingfocused, tends to run a fund that is market-neutral to spreads and rates, and is focused on short-term technical factors and trading spreads between developed-market debt securities. Managers three and four are traditional equity long/short managers that take a fundamental approach to stock selection, taking long positions in companies they think will appreciate and short positions in companies they believe are overvalued. While these two managers exhibit a low correlation with each other (in this case, 0.10), a third equityfocused manager exhibits the same characteristics as well as broader benefits. Manager 11 trades Figure 6. Examples of allocation by manager style Correlation to total portfolio 1.Credit l/s manager (7%) 0.5 2.Credit l/s manager (9%) 0.2 3.Equity l/s manager (6%) 0.4 4.Equity l/s manager (9%) 0.4 5.Smart beta — Reinsurance (11%) 0.1 6.Multistrategy manager (11%) 0.5 7.Discretionary macro-manager (7%) 0.5 8.Discretionary macro-manager (11%) 0.2 9.Systematic macro-manager (9%) 0.6 10.Smart beta — CTA (9%) 0.5 11.Equity l/s manager — Statistical arb. (11%) 0.1 32 towerswatson.com Pairwise correlations 1 2 3 4 5 6 7 8 9 # 11 0.3 –.01 0.2 0.0 0.2 0.2 0.1 0.1 0.1 –.01 0.1 0.1 0.0 0.3 0.0 –0.1 0.2 –0.1 0.1 0.1 0.0 0.4 0.0 0.0 0.1 –0.1 0.0 –0.2 0.2 0.2 –0.1 0.2 0.1 –.01 0.1 –0.4 0.0 0.1 0.2 –.01 0.1 –0.1 0.2 0.0 0.2 0.1 0.2 0.1 0.1 0.3 0.2 0.2 A C 0.6 0.0 –0.2 B B Factor-Based Projections and Stress Testing Volatility and Correlation Stress Testing While back-tested returns are certainly useful for understanding the historical characteristics of a given manager’s portfolio, they are still historic data. This understanding of history, supplemented by transparency and applied to current asset classes, regions, sectors and, in many cases, individual securities that are held by managers, allows for forward-looking analysis and scenario testing. Rather than simply relying on the historical returns of the underlying managers, in this important stage of the process, we map the exposures of each of the underlying managers (e.g., equity, credit, rate, currency, commodity) and attempt to project how the portfolio would have behaved in previous environments given each manager’s current positioning, as illustrated in Figure 7.* This allows an investor to formulate expectations of the future sensitivity of the portfolio to similar stressevent scenarios, as well as material up and down movements in asset classes. Additionally, a considerable amount of quantitative and qualitative effort is employed to project what each manager’s potential downside is based on its volatility profile and, critically, to stress-perceived correlation benefits of each manager that were considered and discussed earlier. This part of the process helps us understand whether there is too much reliance on our perception of worstcase scenarios or the correlation benefits of each manager, especially since during extreme stress environments, volatility levels can significantly exceed normal levels, and correlations can dramatically increase as risk assets sell off in tandem. “While “ back-tested returns are certainly useful for understanding the historical characteristics of a given manager’s portfolio, they are still historical data.” For example, we consider the historical volatility of each manager and the loss implied by a twostandard-deviation move. Then our dedicated hedge fund research professionals, in conjunction with our portfolio construction specialists, will assign a left-tail multiplier to this volatility projection. The multiplier can range from between one and five, and reflects our Figure 7. Projecting portfolio behavior in previous environments 3 2 4 3 Bull market move Bear market move 2 2 1 1 1 0 0 –1 –1 10% shock to commodity prices 30% shock to credit spread 100 bp shock to interest rates –2 –2 10% shock to US$ exchange rate Credit seize 2009 2007 subprime markets TMT bubble bursting September 11 attacks 1998 Russian financial crisis 1997 Asian financial crisis –3 10% shock to equity markets –1 –2 Note: A bull market move is a favorable shift for a particular market; a bear market move is a negative shift for a particular market. . Non-dollar-denominated funds might still show a currency stress test in US$s. For illustrative purposes only — returns are not meant to represent an actual client portfolio. *A third-party risk aggregator is utilized to assist in the calculations. The Hedge Fund Landscape: Our Latest Thinking 33 belief about how vulnerable a manager is to market shocks, particularly those that impact asset classes where the manager is exposed. Position-concentration levels, leverage and the liquidity of the markets in which the manager trades are all examples of things we consider when arriving at a multiplier. Figure 8 illustrates how these figures are used to calculate the portfolio’s returns in stress environments. As illustrated, in our opinion, the worst-case scenario is the very unlikely chance that all managers are perfectly correlated during a stress scenario and that each experiences its maximum projected loss — the result, as one would expect, is considerably worse than the historical two-standard-deviation portfolio return. Figure 8 shows hypothetical expected portfolio losses using the following volatility-based loss estimates: •• Two-standard-deviation event — historical. Based on the realized volatility of past returns for each of the underlying managers •• Two-standard-deviation event — projected. Based on the estimated forward-looking volatility of returns for each of the underlying managers •• Two-standard-deviation event — historical, lefttail adjusted. Based on the realized volatility of returns for each of the underlying managers, with a left-tail multiplier applied to each manager’s historical volatility •• Two-standard-deviation event — projected, left-tail adjusted. Based on the estimated forward-looking volatility of returns for each of the underlying managers, with a left-tail multiplier applied to each manager’s historical volatility While this exercise has a number of uses, perhaps its most important use is to determine the differences in stress-environment returns and their sensitivities to things such as correlation. This also applies on a time-series basis, where changes in these metrics over time can signal an overreliance on assumed correlation benefits or volatility assumptions. Back-Tested Returns In combining the universe of appropriate managers with the guidelines, principles, risk analysis and judgment noted in this article, the portfolio manager will determine an initial portfolio that is expected to meet a client’s objectives. A review of how this aggregate portfolio would have behaved historically is then a valuable analysis, all while overlaying the analysis with qualitative judgment to account for things that are not easily measured (manager conviction, among other factors) before the final portfolio is determined. Figure 8. Hypothetical portfolio losses based on various loss estimates Estimated loss Two-standarddeviation event •• Historical Two-standarddeviation event •• Projected Two-standarddeviation event •• Historical •• Left-tail adjusted Two-standarddeviation event •• Projected •• Left-tail adjusted –5.0% –6.3% –15.4% –19.5% Assuming manager correlations = 0.5 –10.5% –11.7% –32.7% –36.2% Assuming manager correlations = 1 –14.2% –15.8% –42.7% –48.5% Using historic manager correlations For illustrative purposes only — returns are not meant to represent an actual client portfolio. “In “ combining the universe of appropriate managers with the guidelines, principles, risk analysis and judgement noted in this article, the portfolio manager will determine an initial portfolio that is expected to meet a client’s objectives.” 34 towerswatson.com Figure 9. The return profile of our hypothetical portfolio The result is a portfolio with low beta, volatility and downside protection. It is designed to be a complement to existing asset allocation. Volatility versus benchmark (HFRI FOF) is lower despite an 11-manager portfolio versus hundreds. Returns (%) Month QTD Return pa (%) 1 year 3 year Best and worst month SI SI* Volatility (%) SI Sharpe Ratio SI Beta SI Max (%) drawdown Recovery (months) Portfolio 1.02 2.97 7.74 5.51 7.53 2.61 –2.21 3.30 2.04 — –3.40 Objective 0.36 1.08 4.46 4.46 4.88 — — — — — — 2 Benchmark 1.00 3.46 4.88 2.13 –0.22 3.32 –6.54 6.22 –0.16 0.24 –20.11 52 Equities 1.88 6.63 11.19 7.81 1.14 11.49 –19.91 21.31 0.02 0.05 –51.73 50** High Yield 0.88 2.83 10.12 5.85 6.68 12.60 –16.53 15.53 0.38 0.04 –37.68 13 — ** Notes: Equity is MSCI AC Global; High Yield is Merrill Lynch US High Yield Master II. *SI means since inception of the portfolio (April 1, 2008). **Indicates the recovery is ongoing For illustrative purposes only — returns are not meant to represent an actual client portfolio. In Figure 9, we consider the return profile of the hypothetical portfolio that was discussed above and develop back-tested returns for a period spanning several years. Generally, the goals, as specified at the outset of this exercise, were achieved over this period: •• The portfolio would have exhibited lower volatility than equity or credit markets, as well as the benchmark Hedge Fund Research Inc., HedgeFund-of-Funds Index (HFRI FOF), despite having allocations to only 11 underlying managers versus hundreds (on a look-through basis) in the benchmark. •• Further, the portfolio’s beta to equity and credit markets would have been quite low. •• Finally, during periods of market declines and stress, the portfolio would have managed to preserve capital with minimal drawdowns. Finally, once a portfolio is implemented, there should be a formal, ongoing process for review in which many of the same considerations discussed above are again vetted. This ongoing review process is critical since a less-than-robust process and ongoing resource commitment can lead to materially negative outcomes, given the flexibility that hedge funds may have to deviate from previously understood parameters. Both Art and Science The process of constructing a hedge fund portfolio is both an art and a science, and can be very iterative in nature before the final portfolio is eventually implemented. We hope this section illustrates many of the tasks inherent in building an appropriate hedge fund portfolio for a client’s unique situation. Controls and Ongoing Monitoring Critical to the process is the control environment, which we believe is enhanced by including experienced professionals in the approval process who are not exclusively focused on hedge funds to bring additional high-level objectivity. These professionals serve as independent and objective client advocates. The goal at this stage of the process is to incorporate a healthy dose of skepticism about underlying managers in the portfolio and their allocations so that a relationship with a manager, or bias toward a manager or strategy, doesn’t cloud judgment. The Hedge Fund Landscape: Our Latest Thinking 35 Into a New Dimension An Alternative View of Smart Beta The investment landscape is changing. Smart beta,* a concept gaining significant investor interest, is a term we use to cover a broad spectrum of ideas that challenge the traditional black-and-white split between alpha and beta. We believe this is good news for investors. In this section, we: “While “ many of the ideas have been around for years, there has been little interest in using a broader beta set to construct portfolios, in part because good implementation options were not available.” •• Show that some of what was once called alpha can, in fact, be captured as beta •• Develop a broader framework for thinking about returns, adding an implementation strategy dimension to the traditional asset class definition •• Examine the diversification properties of some of the new — or so-called “alternative” — betas that come from this broader framework •• Consider implications for alpha and beta While many of the ideas have been around for years, there has been little interest in using a broader beta set to construct portfolios, in part because good implementation options were not available. We believe this is changing. Therefore, we think that investors should: •• Consider allocating directly to these new betas because they have low correlation to equity and credit markets •• Consider the beta exposures embedded in active mandates and the appropriateness of the fees they are paying for these exposures *See appendix for the bulk beta/smart beta/alpha continuum. 36 towerswatson.com The Alpha/Beta Debate Has a Long and Evolving History Prior to modern portfolio theory, there was no easy way to understand performance — investors could ascribe returns only to manager skill or perhaps luck. However, investors realized their portfolio returns were linked — to a large degree — to a common driver, namely, the performance of the stock market as a whole. The development of the Capital Asset Pricing Model (CAPM) and indexation led to a new way to understand performance: The market (as described by a capitalization-weighted index) was beta, and excess return was active management, or alpha. The idea of market capitalization indexing in other major markets such as government and corporate bonds also took hold. Even in the early days of the CAPM, academics had identified groups of equity securities with certain characteristics — such as value, low volatility and momentum — that offered returns not easily explained by the simple market model. These groups of securities could be described and captured systematically.1, 2 Some ‘Pure Alpha’ Is Captured by Beta The most recent chapter in the debate relates to research on active managers, in particular, hedge fund/returns — once considered the ultimate expression of pure alpha investing. In fact, many studies show that a significant proportion of aggregate hedge fund returns can be explained by beta. To illustrate this point, in Figure 10, we show cumulative returns for hedge funds (as represented by the Hedge Fund Research Inc. Composite Index)3 and a combination of beta investments. The thesis is simple: While individual funds may exhibit pure alpha, hedge funds, as a whole, pick up some common sources of return. This is particularly true for a broad collection of hedge funds, such as those represented by an index. As can be seen, the majority of hedge fund returns have been captured over this period by betas. Hedge funds did outperform modestly, despite the zero-sum game of active management and high fees. On a risk-adjusted basis, however, returns for the hedge fund index and the beta combination are similar. Figure 10. Illustrative cumulative return 250 200 150 100 50 0 c. De 96 c. De 97 c. De 98 c. De 99 c. De 00 c. De 01 02 . 03 . 04 . 05 . 06 . 07 . 08 . 09 . 10 . 11 . 12 . 13 c c c. c c c c c c c c c De De De De De De De De De De De De Hedge Fund Composite Index Beta combination Return over cash % per annum Risk (standard deviation) % Risk-adjusted return Hedge Fund Composite Index Beta combination 5.1 7.4 .69 4.3 5.9 .73 This analysis and the performance figures are backward-looking and intended to illustrate the portion of net hedge fund returns that can be captured by various market betas. The beta combination figures do not represent an actual portfolio return. Results of an actual portfolio invested in this way would vary depending on the timing of transactions, fees and other factors. Products designed to access the strategies utilized may not have been available to investors for all or part of the time span covered here. The hypothetical beta combination being used for comparison is shown gross of fees. The Hedge Fund Landscape: Our Latest Thinking 37 Figure 11 shows the beta allocations broken down for each of the main HFRI categories. As well as bulk betas such as equities and credit, we add alternative strategies such as value or momentum. The allocations are intuitive. For example, long/ short equity strategies have a greater exposure to equity market beta, whereas fixed income relative value strategies pick up bond and credit beta. Similarly, macro hedge funds include an exposure to momentum (trend) following strategies. The Figure 11. Beta allocations matched to hedge fund strategies exposure to the volatility premium across most categories is likely to come from the typical lefttailed pattern of hedge fund returns. We can also assess the importance of beta by looking at return patterns. Figure 12 shows the percentage of monthly hedge fund returns that can be explained by beta — a highly significant 84% for the broad HFRI index. Differences by strategy are again intuitive — higher for equity long/short (more equity exposure) and lower for macro (more idiosyncratic strategies). Figure 13 shows that the finding is also remarkably consistent over time. 100% Figure 12. Percentage of hedge fund returns explained by beta combination* 90% 80% 70% HFRI strategy Percentage Relative value 64% 40% Equity I/s 84% 30% Event 67% Macro 48% Composite index 84% 60% 50% 20% 10% 0% Relative value Equity l/s Event Macro Composite index Alternative beta Carry Vol. premium Momentum Equity value Equity size Bulk beta Credit spread Gov bonds EM equity spread DM equity spread Figure 13. Percentage of hedge fund returns (HFRI composite) explained by beta combination — Rolling three years 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 38 towerswatson.com *R^2 measure from monthly regression of returns — See appendix Visually, the drawdown chart of Figure 14 also shows the closeness of fit: The dips appear at the same time and, broadly, to the same extent. Finally, we offer a note of caution. Our intention is not to replicate hedge fund returns per se or to demonstrate that alpha has disappeared. The analysis is backward-looking and the betas fitted with hindsight. It should also be acknowledged that active managers have been responsible for identifying many of the strategies that are now being commoditized as beta. Nevertheless, the analysis does present some interesting issues for active management going forward (as discussed later). A Broader Framework for Beta — Into a New Dimension To date, beta has been synonymous with asset classes and indices. An asset class groups together securities with similar characteristics, for example, equities or bonds. Once defined for inclusion in an index, the securities are generally buy and hold, changing little over time. As can be seen from Figure 10 (page 37), we include examples of betas that do not fit into a traditional definition. At this stage, it is worth setting out a broader perspective on beta, although we shy away from a precise definition: •• The securities capture a premium for exposure to common sources of risk or return. •• The process has low fees and costs. •• Manager skill is primarily used for access (sourcing or selecting securities) and good implementation. The majority of passive assets globally are in equities and bonds. Because these are simple, cheap and liquid, we refer to them as “bulk beta.” However, under our broader description, we can extend bulk beta in two main ways: •• Implementation strategies. Here we refer to a strategy of owning or tilting toward securities with specific characteristics, and not holding (or shorting) those without.4, 5 Examples are carry (own higher-yielding securities) or momentum (buy securities that have recently appreciated). The idea also includes thematic investing — owning assets with characteristics that should benefit from a long-term investment horizon. •• Extending asset classes to nontraditional areas such as currency or commodities. We also include strategies that are derived from an asset class. For example, the volatility strategy captures a premium for unanticipated volatility in an asset class, rather than returns from the asset class. “It “ should also be acknowledged that active managers have been responsible for identifying many of the strategies that are now being commoditized as beta.” •• Defined processes are applied to select a group of securities with common characteristics. Simplicity and transparency are preferable. Figure 14. Drawdown chart 0% –5% –10% –15% –20% –25% Dec. Dec. Dec. Dec. 96 97 98 99 Dec. 00 Hedge Fund Composite Index Dec. Dec. Dec. Dec. 01 02 03 04 Dec. Dec. Dec. 05 06 07 Dec. Dec. 08 09 Dec. Dec. Dec. Dec. 10 11 12 13 Beta combination The Hedge Fund Landscape: Our Latest Thinking 39 An interesting perspective can be gained by considering this broader beta set in two dimensions (Figure 15). Going down the table, we extend our asset class universe to diversifying areas such as currency, commodities and volatility. (We omit others for brevity.) Across the table, we extend beta to implementation strategies, separated into systematic and thematic ideas. to generate positive returns over time. We discuss alpha a little later within a broader context of skill. All Very Interesting, but Why Bother? As with most things in investment, risk and return are key considerations. A striking feature of these new betas is that they have great diversification properties, both between themselves and — perhaps more importantly — to traditional asset classes.6 To illustrate this, Figure 16 shows correlations for pairs of betas. As can be seen, correlations are highest in traditional markets such as equities and credit. The broader set of betas is not theoretical. The ticks in the table refer to betas where we have found good solutions to implement and continue to investigate new ones. We can also fit traditional alpha neatly into this framework. We would characterize alpha as discretionary processes to select markets/securities Figure 15. Broader opportunity set Systematic Implementation strategies — Examples Return drivers Asset classes Equity Equities Term/inflation Bonds Credit Bonds Currency Currency Insurance Volatility Commodities Carry Thematic Momentum Value EM Deleveraging Alpha Stock selection Market (beta) selection Bulk beta Alternative beta Alpha Figure 7. More diversification from alternative betas Correlation Equities vs. credit Equities vs. value Carry vs. momentum Equities vs. volatility premium Best = lowest Worst = highest 0.33 0.86 –0.72 0.65 –0.40 0.38 –0.10 0.68 Average 0.59 –0.22 0.03 0.22 Rolling three-year correlations from December 1996 to December 2013 40 towerswatson.com Some Implementable Solutions Not all things that can be called beta will necessarily generate positive returns. Our approach is to consider the following questions: •• Rationale — What economic risks or behavioral effects are we capturing, and why should they exist? •• Evidence — What academic or other evidence is there? Do we have out-of-sample tests? Can we independently substantiate the findings? •• Beliefs — What do we believe about the world going forward? Will it be different from the past? We have been researching smart beta strategies for a number of years, often working with the investment community to develop new products from scratch. Figure 17 summarizes the performance characteristics of an implementable alternative beta portfolio shown in Figure 18 and compares it to hedge funds (HFRI index). Figure 17. Illustrative performance summary HFRI index Average return % per annum Standard deviation % Max drawdown % Equity beta % of returns explained by alternative beta portfolio Alpha and Skill — The Role of the Investor This broader beta framework adds a space between bulk beta and alpha. The terms “alpha” and “skill” are often used synonymously, and investors have often outsourced alpha generation to specialist 44 This hypothetical alternative beta portfolio analysis is shown net of estimated fees. Please see appendix for fee assumptions and additional information. This analysis and performance summary are backward-looking and intended to illustrate the portion of hedge fund returns that can be attributed to various market betas. The figures do not represent an actual portfolio return. Results of an actual portfolio invested in this way would vary depending on the timing of transactions, fees and other factors. Products designed to access the strategies utilized may not have been available to investors for all or part of the time span covered here. Figure 18. Example alternative beta portfolio 7.5% 12.5% 7.5% 17.5% As Figure 17 shows, this alternative beta mix would have performed well, especially after adjusting for risk. Sensitivity (measured by beta) to traditional asset classes such as equities has been low. Note also that the alternative betas do in fact explain some of the hedge fund returns, although not by design, confirming the presence of alternative beta in hedge fund returns. 5.4 4.4 –12 0.1 December 1996 to December 2012 The portfolio features: •• Strategies using long and short positions, where relevant, which result in low exposures to traditional markets (and therefore low correlation by design) •• Strategies that can be accessed cost-effectively elsewhere are avoided, for example, equity value can be accessed cheaply in long-only mandates with equity smart betas •• The allocation that uses portfolio construction principles, scaling for risk (including tail risk) and diversity; we do not try to replicate hedge fund returns, per se, with either individual strategies or a combination •• Low management fees relative to existing methods of access (say, 50 bps per annum versus a 2 + 20 hedge fund fee scale) 5.1 7.4 –23 0.4 Alternative beta portfolio 12.5% 25% 17.5% 12.5% 7.5% 12.5% 17.5% 25% 17.5% 7.5% Emerging market currency FX carry Multi-asset carry Volatility premium Reinsurance Momentum Commodities fund managers. However, we think there is an opportunity for investors to capture new sources of returns — as beta — by applying governance or skill in a broader sense. It is fair to say that these ideas require more time and expertise to understand and manage than traditional asset classes. Some of them are, in part, based on behavioral or structural explanations and therefore require investor beliefs about the rationale and sustainability of returns. We might also argue for a complexity premium, available to investors that have or can develop appropriate governance. The additional governance may be a barrier for some investors, particularly those with predominantly simple passive portfolios. “The “ terms ‘alpha’ and ‘skill’ are often used synonymously, and investors have often outsourced alpha generation to specialist fund managers.” Some of the ideas have limited capacity or cyclical return patterns, and their effectiveness may diminish over time. Similarly, over time, new strategies will emerge that can be commoditized as beta. So monitoring and selection of betas is very important — a form of alpha in itself. The Hedge Fund Landscape: Our Latest Thinking 41 •• Manager selection is key. While this seems obvious, there may be a presumption that hedge fund managers are an above-average bunch, and therefore, the usual zero-sum game argument does not apply. While this may be true before fees, it is harder to justify net of fees. As shown earlier, we saw some additional return from hedge funds, but the argument is finely balanced. •• Overdiversified hedge fund strategies risk moving to industry-average returns and therefore closer to the returns that can be captured with beta. This is exacerbated when FoHFs are used. Compared to alpha, the governance emphasis is shifted toward understanding, constructing and managing beta allocations rather than manager monitoring and evaluation. From a clear sheet of paper, we would argue that this broader beta framework entails more up-front governance, but less ongoing governance than alpha. Investors can, of course, have both beta and alpha, and indeed, this is what we would advocate, where governance allows. Implications for Alpha In this section, we make a case that some of what has been labeled alpha can be captured as beta. This is good news, as beta is (or should be) cheaper than alpha. We are not suggesting that alpha is not worth pursuing; genuine alpha is a source of uncorrelated returns and therefore much valued for portfolios. However, there are some implications for active management, particularly for hedge funds: •• Investors should consider the fees being paid for alpha, bearing in mind that some could, in fact, be beta. There is nothing wrong with including beta in an active mandate, providing that fees are appropriate. To help with this, we consider fees as a share of alpha. “Overdiversified “ hedge fund strategies risk moving to industry-average returns, and therefore, closer to the returns that can be captured with beta.” In Summary In Figure 19, we draw together the key messages from this paper. The development of smart beta challenges the traditional split between alpha and beta, building a space between them. This creates an opportunity for investors that have or want to develop the skills to capture these sources of return. While many of the ideas have been around for years, there has been little interest in using a broader beta set to construct portfolios, in part because good implementation options were not available. We believe this is changing. Figure 19. The traditional split between alpha and beta Beta Alpha Old definition •• Returns from passive market capitalization exposure in traditional markets •• Returns from active management New definition •• Returns from broader set of asset classes and strategies that are exposed to common risk (or other) factors •• Returns that cannot be explained by exposure to common risk factors So what? •• Can be considered in a broader framework •• Investor skill needed •• Some of what was alpha is beta Portfolio implications •• Understand beta exposures •• Beliefs in new betas: Risk and return properties •• Consider appropriate exposure to betas (portfolio construction) and method of access •• Pay appropriate fees for alpha •• Consider overall contribution to return from beta and alpha sources •• Focus on true alpha generators 42 towerswatson.com Into a New Dimension: An Alternative View of Smart Beta Appendix Bulk Beta, Smart Beta and Alpha •• Bulk beta — Traditional market cap passive investment in core asset classes such as equities and bonds. Bulk beta should be simple and liquid. •• Smart beta — Strategies that move away from market cap indexation in traditional asset classes. We therefore include nontraditional asset classes and systematic processes to capture common sources of risk or return. We divide smart beta strategies into three areas: •• Diversifying. Alternative asset classes that have low correlation with traditional markets •• Systematic. Strategies that capture new risk premiums or exploit inefficiencies in market cap investing •• Thematic. Capturing mispricing opportunities by being a long-term investor As far as is practical, strategies should be beta-like in nature — simple, low cost, transparent and so on. •• Alpha — Discretionary process to select securities and/or markets. Alpha cannot be explained by either bulk or smart beta. Beta and Hedge Fund Regression Results •• Data from December 1996 to December 2013 •• Sources: HFRI, FTSE, MSCI, Merrill Lynch, AQR, Ken French, Bloomberg, Towers Watson •• Beta strategies used: •• Developed-market equities: U.S. equities •• Emerging-market equity spread: Emerging-market equities less global equities •• Government bonds: U.S. government bonds •• Credit spread: U.S. high-yield bonds less U.S. government bonds •• Equity size: Fama-French U.S. size factor •• Equity value: Fama-French U.S. value factor •• Momentum: Multi-asset trend following strategy based on prior 12 months’ performance •• Volatility premium: Short volatility strategy on the S&P 500 index •• Carry: FX carry strategy represented by 1.8*FTSE FRB10 index R^2 is a statistical measure giving the percentage of monthly return variation that can be explained by a given strategy. In this section, we show the percentage of the variation in hedge fund returns that can be explained by a combination of beta strategies, with the allocations shown in Figure 11. The beta allocations depend somewhat on the way in which strategies are defined, as well as the time period used. Nevertheless, the broad conclusions in this paper are valid. Illustrative Performance Summary Fee Assumptions •• Beta strategy returns being analyzed are a combination of manager back-tests, indices and live data. •• A 3.5% per annum penalty has been applied to manager back-tests and index returns as a broad deduction to account for fees, expenses, trading costs and survivorship bias. •• Where manager live data were used, the data are net of fees. •• An additional 40 bps per annum was deducted across all strategies to simulate an investment advisory fee. Endnotes 1. Many of the alternatively weighted equity strategies capture common betas such as value and small cap. See for example, “The Surprising ‘Alpha’ from Malkiel’s Monkey and Upside-Down Strategies,” Arnott, Hsu, Kalesnik and Tindall, Journal of Portfolio Management, summer 2013. 2. Within equity stock selection, these risk premiums are often referred to as “style premia.” The ideas come from work by Fama-French (value and small cap), Jegadeesh-Titman and later, Carhart (momentum) and are not new. The work on style premia has largely been used to understand and attribute active equity manager performance, rather than to consider the merits of the premium on a stand-alone basis. In part, this reflects controversy over the sources of return and dominance of thinking around the efficient market hypothesis. 3. The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to the HFR database. Constituent funds report monthly, net of all fees, performance in U.S. dollars and have a minimum of US$50 million under management or a 12-month track record of active performance. The HFRI Fund Weighted Composite Index does not include funds of hedge funds. 4. The selection of desirable assets could be at the country or sector level, rather than individual security level (e.g., weighting equities toward lower-cost countries or sectors). In other asset classes, this makes more sense (country selection for government bonds) or is the only choice (there are no securities in FX). 5. It is possible to isolate the pure risk premium by constructing long and short portfolios — holding securities with desirable characteristics and shorting those with undesirable characteristics, balancing holdings in such a way as to remove or significantly reduce the underlying market risk. This approach is often used in academia, for example, with the Fama-French value and small capitalization factors for equities. In practical terms, the cost of doing this needs to be carefully considered. Implementation with liquid futures markets makes the approach more cost effective. For stock-selection strategies, long/short strategies are less cost effective. Access to premiums can be achieved in long-only portfolios by tilting toward desirable characteristics, depending on the exposures to the premium needed. 6. This does not guarantee future diversity. We are aware of the potential for correlation and downside risks, depending on the specific strategy being considered. The Hedge Fund Landscape: Our Latest Thinking 43 Summary Hedge Fund Research: Time and Effort Well Spent We hope the information and analysis in this book will be helpful to you in your future deliberations over hedge fund allocations. We have demonstrated 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. 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. 44 towerswatson.com Towers Watson has considerable expertise in this area and for years has helped clients to navigate their way through the issues. But we recognize there are no right or wrong answers and that this book forms part of an ongoing dialogue about the options available. In that respect, as in others, we look forward to your feedback and comments. Please note: This document was prepared for general information purposes only and should not be considered a substitute for specific 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 financial decisions, and no such decisions should be made on the basis of its contents without seeking specific 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 Watson’s 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 affiliates, and their respective directors, officers 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. About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 15,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Learn more at towerswatson.com. Copyright © 2015 Towers Watson. All rights reserved. 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