The New Alternative

The Monetary Authority of Singapore (“MAS”) classifies investors into 3 classes under the Securities and Futures Act – “accredited investor”, “expert investor” and “institutional investor”. There is no classification for retail investor specifically, and generally all other types of investors fall under this classification. The banking sector has been hit hard all around the globe, including Singapore. However, a key difference in the drama in Singapore’s financial sector from other countries’, is not due to bank closures but to individuals (retail investors) losing their life savings by investing in an instrument that was one thought to be untouchable by any market downturns –Lehman Brothers Bonds that were rated A1 by credit-rating agency Moody’s as late as July 2008. Who were the victims of this onslaught and how were they exposed to these instruments in the first place? Are there other investments that the same investors are exposed to and are they aware of the risks of those investments? How can the MAS find the middle ground it needs to prevent something similar from happening again, without over-regulating the financial system in Singapore?

Mr Tharman Shanmugaratnam, the Finance Minister of Singapore was recently quoted as saying ‘The MAS approach is one that balances regulation with responsibility on the part of the institution and the investor. All three play a part, and in all three areas, I’m sure there can be improvements, coming out of the recent problems.’

The Issue

The Monetary Authority of Singapore said about 9,700 people had bought Lehman-linked structured notes worth over S$500 million, and due to the recent Chapter 11 bankruptcy filing by Lehman Brothers, investors in these notes would lose most of their investments. Recently, about 600 investors in Lehman-linked derivatives held a public meeting in Singapore to protest about the way banks sold them the investment products and to discuss ways to get compensation, according to news sources. The problem with Singapore’s financial system is the way financial instruments are being sold and the way sales people are trained and motivated to sell them.

Quoting from the same source:

‘They never told me the issuer was Lehman and I told the manager I was afraid of American banks,’ said Ms Lin Ling, who bought S$60,000 worth of Lehman-linked ‘Minibonds’ from a Singapore finance firm that had marketed the structured notes as a safe alternative to fixed deposits.

‘I didn’t know it’s Lehman. There’s no Chinese explanation,’ said a lady in her 60s who identified herself as Madam Lee. ‘I don’t want interest, I just want my deposit back.’

Back in May this year, I wrote a post about Funds of Funds and how they were little more than an additional layer of fees for their investors. In recent market mayhems, Funds of Funds were expected to prove themselves and provide the un-correlated returns of the markets, due to their arguable diversification abilities.

It does look like I’m not the only one raving about the gloomy outlook for Fund of Funds operators. The Wall Street Journal recently reported that Fund of Funds have fallen about 11 percent in value. Eurekahedge’s Global Fund of Funds Index is down a shocking 11% YTD as of the time of this post, performing worse than the EH Asian Index which is down 9.85%. It’d be really interesting to see an FOF operator convince potential/existing investors about their lower volatility relative to the single funds’.

Something interesting appears to be happening in the FOHF scene though, something innovative. Hedge Fund news websites reported that Permal Investment Management Services launched a Fund Of Funds to buy shares in hedge funds at sizeable discounts (25 to 30%) to their market value as more investors become distressed sellers.

Stefan Nielson over at the Tokyo Hedge Funds Club is putting together another signature year-end party for hedgies in the Land of the Rising Sun. The event is strictly by invitation only, and is organised specially for  for hedge fund managers and investors at the exclusive Roppongi Hills Club. Confirmed sponsors include CME Group, J.P. Morgan TSI International and Fidessa.

For more information, please contact the Tokyo Hedge Funds Club at tokyo@hedgefundsclub.com or visit http://www.hedgefundsclub.com.

From my experience working with emerging hedge fund managers and especially from a recent Terrapinn conference I attended as a speaker, I discovered a very grave question raised by aspiring hedge fund managers:

“Where can I find Seed Investors?”

This question is prima facie an innocent, practical question that one must ask prior to starting a hedge fund business. Looking deeper however, I realized that individuals who ask this question are all set to build a house of cards, not a long-term business. Seed investors are everywhere. Your family, friends, colleagues, ex-boss, ex-wife, heck, even you could possibly be your own seed investor. By my definition, a seed investor is anyone who provides significant risk capital to a new venture. To be much more precise, institutional seed investors typically are made up of Funds of Funds, Family Offices and High Net Worth Individuals, more so than pension and endowment funds.

A point that I feel must be put across to emerging fund managers is this:

“It is as important for you to select and monitor your investors,

As it is for your (potential) investor to select and monitor you.“

The same laws of the markets that govern hedge funds also govern their investors. It is important for emerging managers to compare and constrast the various investors available to them, by comparing the investment size, time horizon, deal structure and the business sustainabililty of the investor. This is especially important when selecting a seed investor. Depending on the expertise of the team put together by the Emerging Manager, the requirements from seed invesotrs will range from operational support, marketing support, risk monitoring support and so forth. It is important that such support is provided for the right reasons (i.e. provided because the Emerging Manager actually needs such support, and not because the seed investor requires it by protocol).

A thin line separates between “value-adding” and “getting in the way”. Regardless of the deal put together, the Manager must seek to maximize the control he has on his business (read: not his investor’s business). Nobody - not even the seed investor - knows his portfolio better than the Manager does. Will having an institutional seeder influence the investment decisions of other investors? As long as herd behaviour drives the human society, this will always be true.

Felix.

This article was first conceived by a thought of mine that, among other things, culture differences within the ranks of a hedge fund company could possibly influence the performance of the fund. Rather than subjecting myself to being a participant in the ongoing statistical warfare, this article’s topic was switched from one that would be subject to personal objectivity, to another that is more impartial. What I seek to share in this article is the (possible) presence of cultural conflicts within hedge funds and their management companies in Asia, and some negative implications these conflicts may bring.

Investors and academics have always challenged themselves (and each other) with the Herculean task of identifying the “best” hedge fund. How is performance determined? How does one consider the risk a hedge fund is exposed to? Does understanding the strategy equip one with the capabilities to predict either of these factors? As the industry matures, investors and academics have also grown. Experts have moved on and determined that even having a complete understanding of the quantitative scores of hedge funds (who are mostly un-regulated pools of investments, relative to their mutual fund counterparts) is insufficient to warrant an investment. Some experts assert that operational weaknesses cause easily as much trouble for hedge funds as do market stresses. Others have gone ahead to write papers on the topic of managing the operational risks of hedge funds.

As indisputable as it is that both quantitative and qualitative components of a hedge fund contributes directly or indirectly to its performance and sustainability, one must not ignore the genesis of it all – the people behind the fund. For the purpose of completing this article, I conveniently assume that hedge funds are usually made up of at least two people, and the people managing hedge funds, like any other person on the street make decisions based on memory and reasoning. And like you and I, these people’s decisions are influenced by their culture. The Founder and Chair of EIM Group, Arpad Busson, rightfully said in an interview with Newsweek: people are at the heart of every success.

Hofstede’s Cultural Dimensions

In the late seventies, as an anthropologist from the Netherlands, Geert Hofstede conducted in-depth surveys and interviews with a large number of employees working for IBM in 53 countries. Using standard statistical analysis on his findings, Hofstede determined patterns of similarities and differences among the responses. He then formulated his theory that cultures around the world vary along consistent dimensions:

• Power Distance Index (PDI)
• Individualism (IDV)
• Masculinity (MAS)
• Uncertainty Avoidance (UAI)
• Long-Term Orientation (LTO)

Power Distance Index

A hedge fund management company with high PDI may have in place a more rigid investment process, with possibly a single fund manager making the final investment call. When analyzing such companies, it may be useful to focus one’s attention to the expertise and responsibilities of the individuals in the higher ranks of the hierarchy. Problems may brew unexpectedly if the “alpha males” are no longer regarded as competent by other members of the company. Problems could range from basic employee frustration to employee turnover. Companies with high PDI may also be more prone to key man risk, relative to companies with low PDI. Information integrity may also be an issue, as it may be possible that all information provided to external parties will first be filtered by a senior member of the company. If one has a preference for analysis through interviews with lower-level employees within a hedge fund company, this may pose as an obstacle.

Individualism

Hedge fund companies whose employees are mostly individualistic tend to risk a lack of communication and possibly introduce unnecessary misunderstandings which may affect the daily operations of the hedge fund. Depending on the role of the individual, however, individualism might not be a negative culture. For example, the marketing person may have a highly-individualistic culture without causing trouble to the running of the hedge fund. However, if the trader is an individualist, one can only imagine the risks that may bring. A research on motivation says that effort and performance are a function of both the outcomes individuals anticipate will result from them performing an act and their efficacy expectations. If key decision makers within the company are mostly individualists, subordinates may not be properly rewarded hence once again causing discontent, bringing with it all possible disasters.

Masculinity

Generally, this dimension affects little in the management and continuity of a hedge fund except in instances of funds who have large gender dispersions, or funds who are managed by women. This may pose some risk as the other members of the team may not respect her enough to follow her operational procedures. Being a woman in a senior management level in a team that is high on the masculinity index may also pose a threat to teamwork in general.

Uncertainty Avoidance

It is natural for humans to avoid situations in which we are made to feel uncomfortable, and our cultural perceptions and expectations control our degree of desire in which we seek to avoid these uncomfortable situations. Form a qualitative due diligence point-of-view, a high uncertainty avoidance measurement gives an analyst some assurance that the hedge fund will operate the way it promised to operate in their initial pitch. A trader and/or fund manager with high uncertainty avoidance is less prone to change their trading/investment strategies (style drift), whereas one with a lower uncertainty avoidance may be more likely to do so.

Long-Term Orientation

Hedge fund companies with a higher LTO tend to take a longer view on most things, including the hiring of staff and the performance of their fund(s). They may pay more attention to their longer term performance rather than the short term performance (yearly performance rather than monthly performance), relative to hedge funds that have a lower LTO. Hedge fund companies with a higher LTO may also pay more attention to building up their business infrastructure and may choose to strengthen their middle/back-office staff before the front-office staff. Comparatively, low LTO hedge funds may be more focused on the nearer term and probably will put more emphasis on strengthening their research and front-office staff.

Conclusion … yet another evolution in the alternatives investments industry

Qualitative analysis is more of an art than a science. Typical qualitative analysis is done using the industry-accepted AIMA generic operation due diligence questionnaire for hedge fund managers. While these questions are arguably well-structured and covers most qualitative aspects of managing a hedge fund, an analyst should view each hedge fund company (and their employees) from a cultural perspective. Doing so makes the analysis process more effective and applicable, rather than a “cut-and-paste” task.

Felix.

Middle East economies are booming (no pun intended).

Leaders of the Sheikdoms have decided their nations need to be less dependent on oil and have begun massive investment in the attempt to diversify the local economy. A small pool of international hedge funds have already entered into the markets by launching regionally-focused vehicles. The Abu Dhabi Investment Authority, Kuwait Investment Authority and Qatar Investment Authority are among a group of Middle East funds with assets estimated to be worth $1.5tn.

The Boston Globe earlier this month reported that recently, partners from major US private equity firms flew to Abu Dhabi, Kuwait, Saudi Arabia, and other destinations in the region to court wealthy investors. For all but a few, this is brand new territory. And it’s paying off: Billions of dollars from the Middle East have poured into these funds over the past six months, and more is being pledged.”

Bader Mohammad Al-Sa’ad, managing director of the Kuwait Investment Authority, which manages $250 billion, said he expects money from the Middle East to keep flowing into US hedge funds, even with the recent slowdown in buyout deals. “With this crisis, we’re going to see private equity firms going back to the basics,” and perhaps using less leverage, he said in an interview. “We’ll see a lot of opportunity.”

In the Middle East, a tenet of Islamic finance remains a bar on selling something you do not own, tearing away one of hedge funds’ main tactics: shorting companies and using leverage. As the credit crunch and stock market meltdown hit markets around the world, investors outside the Middle East are now beginning to look for investment vehicles with healthy returns that are based in stable environments.

Structured products based in the Middle East, particularly hedge funds, are perfect examples.

Bahrain leads the region with 57 funds worth around US$2.6 billion, and Dubai is determined to establish a competent global hedge fund centre.

As global investment banks flock to the region, they have started to provide synthetic, OTC products that fund managers can use to mimic shorting stocks, through transactions such as equity swaps and other derivatives.

Regional players have started to utilize these hedging tools to cultivate the green shoots of a hedge fund industry, finding counter-parties in institutions such as Deutsche Bank, Merrill Lynch and Credit Suisse. Citigroup’s decision to relocate Alberto Verme, the co-head of its investment banking unit in London to Dubai, is the latest in a line of high-profile transfers to the region.

When will you begin your Journey to the (Middle) East?

Felix.

The A word. A word that hedge funds are always quick to disassociate themselves with, for fear of a regulatory backlash. While many argue that hedge funds are no different from a regular business considering the presence of risks and rewards, regulators seem to think otherwise. The SEC thinks that hedge funds should not market themselves to potential investors, unless those potential investors agree to a declaration form that is too long. Many hedge funds have hence moved to password-protect their websites so that only pre-screened visitors can access performance details. The rationale? Showing performance numbers are seen as solicitation of investors, regardless of whether they are positive or negative numbers. Interesting.

News reports have recently been publishing articles on the chronicles of Phillip Goldstein, who two years ago successfully sued the SEC and overturned a rule requiring hedge fund managers to register as investment advisers. Goldstein is now reportedly planning to sue the regulator to lift its ban on hedge fund marketing and advertising. While it does seems like a long shot to victory, at least someone’s trying to faciliate the evolution of the alternatives industry. One point I made on the NYTimes blog that carried this article, was the fear that even if Goldstein wins the suit, he will only have won the battle, not the war. The internet is a global space, think about that. What difference does one regulator make, when the internet is so loosely governed, if at all.

“The only websites required to pre-qualify people are hedge funds and pornography“

- Philip Goldstein

In my opinion, hedge funds have been advertising to the general public for decades. As a guest anchor on Bloomberg and CNBC, as a panelist in a conference, as a speaker in a university endowment fund function, and now even on your iPod! (link) Hedge fund databases have also arbitraged on the legal restrictions to slap fees on hedge fund managers, their investors and practically any other individual who is willing and able to pay the price, for access to these (marketing) data.

No amount of regulation will restrict our ability to innovate and evolve.

Funds of Funds are typically seen by investors as experts in picking the right (alternative) investment target s- hedge funds - in all market cycles (so are hedge funds, but that’s a different story altogether). They are seen as bridges to higher return on lower volatility and originators of upcoming hedge fund stars.  For doing so, Funds of Funds charge a layer of fees that on the average are lower than the average 2%/20% fees charged by single hedge funds, and from years ago to possibly years ahead, investors will probably continue to invest with these Fund of Funds and continue to pay an additional layer of fees.

(photo: This is San Francisco by Sutanto / © All rights reserved)

Market players estimate that Funds of Funds manage about half of the assets invested in the alternative investments industry. According to Lipper, retail funds of funds that pick from the whole hedge funds market returned an average of over 10% over one year to October 31 2007. Hedge Fund Research (HFR) estimated the average performance of hedge funds to be a little more than 10% for the same year. An investor worth his weight never leaves out the risk (or volatility) when considering an investment, but since both Lipper and HFR chose to leave the average volatility these hedge funds and Funds of hedge Funds went through for the year, I will assume that they are similar - for the sake of completing this post. Taking these numbers with a pinch of salt, I find it difficult to justify paying additional fees to the Fund of Funds manager if performance was the primary pitch for Fund of Funds.

Investors in Funds of Funds also hope that their managers are at the root of the grapevine, listening in on every conversation and idea in the industry to try and spot the next performing fund. As originators, Funds of Funds managers spend most of their time at conferences, seminars, networking events and meetings in order to keep abreast of the latest trends in the hedge fund market. With the explosive growth of the internet, cost-conscious Funds of Funds are beginning to replace such on-the-ground research with subscriptions to hedge fund databases (HFR, HF.net, etc) and news sources (Opalesque, EurekaHedge, etc). Instead of attending meetings in person, Funds of Funds are also beginning to save operations costs by making Skype calls. The maximum trading frequency of a Fund of Funds? Once a month.

Dow Jones recently reported (link) that the proportion of U.S. pension assets overseen by Funds of Funds fell to 49% on September 30 from 57% in 2002. It states that the shift away from investing through Funds of Funds reflects an increasing confidence among institutional investors in choosing their own hedge fund investments. Could this be the real reason? Were institutional investors never confident in choosing their own hedge fund investments before this data was published? Probably, but possibly not. It seems to me that the re-emergence of the Internet as a tool for data sharing and collaboration is starting to empower investors more than before. Funds of Funds used to be a bridge to industry information, now that bridge is starting to be substituted by another - Internet 2.0.

Evolution is never selective. Hence, as this alternative investment industry grows into what we can only imagine today, Funds of Funds must also evolve and change.

I  would love to hear some comments on these thoughts of mine.

Felix.

The Financial Times reported today that a growing number of fund managers are starting to slash their management and performance fees in the hope of attracting investors to their (current and new) funds. The report mentioned two funds in particular - $3bn London hedge fund Endeavour Capital and the $2.5bn flagship fund of New York’s Drake Management - offered to waive performance fees until a certain hurdle is reached.

In my opinion, there are two schools of thoughts:

1) Pennies or Dollars? Why would sophisticated investors be concerned with paying 2% management and 20% performance fees if they expect the fund to generate returns that are above that and the risk-free rate combined? Reuters reported (link) recently that the hedge fund industry attracted a record $194.5 billion in new money last year. Mentioned in the same report, Hedge Fund Research (HFR) estimated the average performance of funds to be more than 10% for the year.

Since performance numbers are usually reported in Net terms (i.e. after all fees), investors made money on their investments on the average, even after paying the typical 2%/20% fees. It is probably arguable that these investors would not lose any sleep at night over whether they got a fee discount or not, would they?

2) Fees are guaranteed losses, unless you get lucky. Bloomberg recently published an article on Nassim Taleb, the author of the (in)famous Black Swan and Fooled by Randomness. Taleb attributed most things to luck, and if investors buy into his theory, then the need for fee discounts or waivers become amplified. Fees, even if they are only 2% per annum, are fixed. Although the fund’s performance itself is no guarantee, performance fees are also fixed to a certain extent. Looking from this perspective, on top of taking capital risks (unknown), the investor is paying additional fees (known) to the manager, without any guarantee of recovering those fees. An investor might hence feel that this double layer of risks/fees should be thinned to the minimum where possible.

While investors may leap for joy when being relieved from the burden of (subjectively) high fees, they should also remember the times they last bought anything at a discount or firesale. On the other hand, many predicted the practice of lowering hedge fund fees to continue to attract investors, and this seems to me like the start of the commoditization of an alternative investment product.

When investors start looking at fee discounts and placing them at an equal importance as the other investment considerations (performance, operations, etc), the barrier to entering the hedge fund industry will be raised. Will only the good managers be left then?

Probbly not, but this is another topic for another day. I will leave this post as it is now.

Cheers.