Transcript Slide 1
P ARKER G LOBAL S TRATEGIES , LLC
How to Incorporate Hedge Funds into a Portfolio
Virginia Reynolds Parker, CFA Founder & Chief investment Officer
“
You've got to go out on a limb sometimes because that's where the fruit is.”
Will Rogers
Primary Impediments
Primary Impediments to Hedge Fund Investing Headline Risk Returns will come down (and correlation up) As more money enters the market Lack of Investment Process Transparency Can’t get comfortable with the fees (both HFs and FoHFs) Too Large to put enough capital to work 34% 31% 14% 12% 9% Source: Casey, Quirk & Acito and The Bank of New York (2004)
INVESTING CONSERVATIVELY
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”
Will Rogers
Keys to Investing Conservatively
Expertise & Experience
• Hire expertise Consultant or FoHF
Diversification
• Limit manager & strategy risk
Disciplined Monitoring
• Develop a framework
Embrace Evolution
• Be among the Fittest
“Experience is the name every one gives to their mistakes.”
Oscar Wilde
The Learning Curve
2007 Sub-Prime & Credit Crisis 2000 Tech Bubble Bursts 3 year bear market 1998 Russian Default, LTCM Spreads widen 1994 Surprise Fed Tightening Mortgage, Bonds, EM Collapse Demise of the 3 Davids 1989-1990 S&L Crisis Collapse of HY Market
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Time 2000 2001 2002 2003 2004 2005 2006 2007 2008
Risk-Adjusted Performance Comparison Alternative Investment Strategy Universe 10 Year Risk-Adjusted Returns
0 -2 8 6 4 2 18 16 14 12 10
Hedge Funds S&P 500
Scaled to 5% Annualized Volatility
Correlations to HFR Hedge Fund Index January 1998 – 2007Q3
1 0.75
0.79
0.72
0.5
0.25
0 -0.25
-0.14
-0.22
-0.5
JP Morgan Global Bonds Index Lehman Aggregate Bond Index MSCI World )local( S&P 500 0.19
GSCI TR Index
Investment Strategy Universe Performance in the Tough Years
Diversified Strategies
Hedge Fund Index Fund of Funds CTA Index
Market Strategies
Fixed Income Foreign Exchange Market Timing High Yield
Global Strategies
Macro CTAs (Discretionary) CTAs (Trend-following) CTAs (Diversified) Emerging Markets
1990
5.8
17.5
27.3
6.5
37.6
13.5
(12.1) 12.6
21.4
29.0
19.8
(3.4)
1994
4.1
(3.5) (0.7) 7.6
(2.0) 3.5
1.5
(4.3) (1.0) (5.7) 5.3
3.8
1998
2.6
(5.1) 9.4
(2.0) 5.6
24.8
(5.3) 6.2
7.4
9.2
11.6
(33.0)
2000
5.0
4.1
6.2
3.4
7.3
11.8
(3.0) 2.0
3.7
5.7
8.1
(10.7)
2002
(1.4) 1.0
12.0
6.5
8.0
3.3
5.8
7.4
8.5
9.6
12.4
3.7
2007
8.8
8.5
5.5
2.5
2.1
8.1
(0.3) 8.4
10.9
5.0
7.5
20.4
Investment Strategy Universe Performance in the Tough Years
1994 1998 2000 2002 1990
Asset Classes
S&P 500 MSCI EAFE JPM Global Gov't Bonds Lehman Gov't Bonds GS Commodity Index (6.6) (24.7) 6.96
9.0
(6.1)
Equity
Equity Hedge Equity Non-Hedge Short Technology 14.4
(7.2) 36.2
n/a
Arbitrage
Market-Neutral Convertible Merger Relative Value Distressed Fixed Income 15.4
2.2
0.4
13.3
6.4
10.8
(1.5) 6.2
(3.5) (2.9) 5.3
2.6
5.1
18.5
10.1
2.6
(3.7) 8.9
4.0
3.8
11.9
26.7
18.2
13.2
8.7
(35.1) 16.0
9.8
(0.5) 28.4
8.3
7.7
7.2
2.8
(4.2) (10.3) (10.1) (15.2) 8.3
11.6
49.7
9.1
(9.0) 34.6
(15.3) 14.6
14.5
18.0
13.4
2.8
4.8
(23.4) (17.5) 8.5
10.3
32.1
(4.7) (8.5) 29.2
(16.5) 1.0
9.1
(0.9) 5.4
5.3
8.8
2007 7.7
10.9
3.4
3.8
18.8
10.0
12.3
0.5
12.7
4.2
4.8
7.3
6.4
5.4
3.6
Investment Strategy Selection
Rigorous Research on the Following Considerations: Universe analysis of investment strategies Predictability and robustness of return expectation Liquidity of positions Diversification among strategies Risk-adjusted returns Sharpe Ratios and Implied VARs Operational complexity Current market opportunity Exposure to extreme risk
Funds of Hedge Funds
“Price is what you pay. Value is what you get.” Warren Buffett
Manager Selection
Quantitative - where consideration should begin
Performance Analysis
relative to market opportunity and operational demands
Risk Analysis
variance of returns recovery liquidity amplitude of drawdowns & operational market Qualitative - where the decision should be made Rigorous due diligence Experience of key professionals Depth of staff Operational controls and timely reporting Industry reputation Sufficient transparency of positions and process
Final Allocation
Practical application of modern portfolio theory Limit manager/strategy concentration Optimize portfolio allocation given constraints including maximum and minimum allocations Apply traditional models with static inputs; consider models with dynamic parameters Consider current market conditions Scenario analysis & stress tests Expected returns Expected risks Expected shortfall across strategies
MANAGING HEDGE FUND RISKS
“Risk comes from not knowing what you're doing.”
Warren Buffett
Risks Involved in Alternative Investment Strategies Same as traditional strategies: Market Structural Market Change Credit Liquidity Legal Operational Human Performance Shortfall
Successful Risk Management
Policies and Procedures Middle Office – The Independent Inspector Quantitative Models Strict Accounting Standards Savvy Managers
The Quantitative Tools
Value at Risk Contribution to Risk Incremental Risk Stress Testing Key Drivers Factor Analysis Scenario Analysis Monte Carlo Recursive Models Downside Deviation Minimal Acceptable Return Maximum Acceptable Loss
BarraOne
Local Market Risk
BarraOne
Global Factor Risk
BarraOne
Total Risk
“Success is a lousy teacher. It seduces smart people into thinking they can't lose.”
Bill Gates
Amaranth
Multi-strategy fund launched $600 million in 2000 with significant convertible arbitrage component 14.72% Compounded return net through November 2005 Perfect storm in convertible arbitrage begins in May 2003 – lackluster returns are large redemptions over the next few years Trying to maintain returns where most components of arbitrage related multi-strategy funds had fewer opportunities 2002 added energy trading , August 2006 had 51% of the open interest
Source: CISDM
Amaranth
Growth of $1000
Source: CISDM
Amaranth
Monthly Returns
Amaranth
Style Drift
Reckless Risk Management
Bad Investment
Cornered Market trapped in a roach motel
US SUBPRIME MORTGAGE MARKET: TICKING TIME BOMB •
25% of the US mortgage market was subprime in 2006, accounting for $722 billion of loans originated
• Borrowers were accustomed to refinancing
when ARMs reset – now
interest rates are increasing home equity is decreasing
• Foreclosures are up 60-70% over 2006
(end of the process)
• Foreclosure notices are up 127% over 2006
(start of the process)
• • Bond investors stand to lose up to $75 billion
in securities backed by subprime according to PIMCO $100 billion of subprime debt went in $375 billion in CDOs in 2006
ARM RESETS
SUBPRIME MORTGAGE CHARACTERISTICS OF ABX INDEX
FICO of approximately 630 50% are cash-out refinancings Loan to Value > 80% 30% have 100% financing 30% are in California 42% have limited documents (merely stating income) 40% Debt-to-Income Ratio 84% of loans are ARMs (adjustable rate mortgages) 7.3% Teaser Resets to Libor + 600 bps
Performance of ABX A 06-2
Summary Diversify managers across markets, strategies and Invest in people , not in numbers Clearly understand strategies annual basis you select, where the majority of the universe is profitable on an Place a premium on transparency hedge fund managers , whether investing in a fund of funds or directly with
Hedge Funds Can Perform Growth of $1000 January 1990 – 2007Q3
10,500 9,500 Bull Market HF Index 8,500 7,500 Bear Market 6,500 5,500 Bull Market 4,500 3,500 2,500 1,500 500 Start Dec 90 Dec 91 Dec 92 Dec 93 Dec 94 Dec 95 Dec 96 Dec 97 Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 S&P 500 Global Bonds MSCI HFR Hedge Fund Index MSCI World (local) S&P 500 JP Morgan Global Bonds
P ARKER G LOBAL S TRATEGIES, LLC 1177 Summer Street Stamford, CT 06905 Phone (203) 358-4000 • email: [email protected]
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