Can Retail Investors Profit From Hedge Fund Access?

Alternative investments are as broad and vague an area as any other within the financial services industry. I have defined for myself alternative investments to be anything other than a long position in stock or bond related holdings. Some may consider commodities and real estate should not be categorized as alternative investments since the ownership of gold and land has been a more traditional manner of investment throughout human history.

The semantics of these asset classes is not important to me. What I believe to be important is how these asset classes, in conjunction with the traditional “stock and bond” portfolio, have an effect on the portfolio’s overall performance. Of particular interest to many investors in recent years are the newer alternatives of hedge funds and private equity investments.

Recently, a significant amount of buzz has been generated on the launch of a new private equity oriented ETF from PowerShares, the PowerShares Listed Private EquitySM Portfolio (PSP). There's been considerable press of late related to the various obstacles and areas of concern regarding private equity investing. However, it is an area seeing continued infusion of institutional funds as well as that from individual investors. The ETF may just be the first step in private equity investing for the masses. From the HedgeWeek.com website, a site with a surprising amount of ETF related news, I find this recent article on a new private equity index. From the article:

The Private Equity Index [PRIVEX] provides investors with access to the upside of diversified private equity performance combined with daily liquidity.

Based on this article, perhaps PSP won’t be a “one-hit wonder” and we may soon see an ETF linked to this new private equity index which is a collaborative effort between Société Générale Corporate & Investment Banking and Dow Jones Indexes/STOXX. According to the article:

PRIVEX tracks the performance of globally listed private equity stocks and is composed of the 25 largest and most liquid stocks of private equity companies listed on the world's stock exchanges. Dow Jones Indexes is responsible for the selection of the index components, the index calculation, the ongoing maintenance and the index dissemination.

The piece goes over the same positive attributes mentioned in press releases and marketing material for PSP including:

· Strong returns for private equity over long periods

· Uncorrelated performance to other asset classes

· Low investment minimum relative for this asset class through an ETF

· Good liquidity relative for this asset class through an ETF

· Transparent exposure

· Good diversification from a basket of underlying securities

All great qualitie,s although I continue to see new ETFs being offered with a relatively small number of underlying positions. Is this private equity index, in addition to PSP, the start of a potential trend in the alternative investment space? But wait, there’s more!

Also found this week on the Albourne Village website (Another good site for hedge fund related news. It’s free but requires registration):

01/11/2006 Fortress Pioneers First Hedge Fund IPO in US

The Financial Times reports that Fortress Investment Group, a US-based alternative investment firm with more than $24bn (£12.6bn) in assets under management, is set to file next week for an initial public offering that could value it at up to $8bn.

The Fortress IPO will be the first public listing of its kind in the US. The float will provide the first test of investor appetite for publicly traded hedge funds in the US and represents a tipping-point for the rapidly growing $1,200bn market. Hedge funds have increasingly been looking for ways to sustain their businesses and Wall Street investment banks have been increasing their exposure to the sector. Analysts said a successful float by the company could pave the way for other large hedge funds looking to form publicly traded asset management companies and lead a rush to the public market.

This type of publicly listed hedge fund instrument has evolved over a short time in the UK and now we’re getting the first glimpse of it in the US. It’s the very last few words above that I think should catch your eye: “… and lead a rush to the public market”. The continued retailization of hedge funds… one of the big debates out there today.

In addition, according to Alternative Universe, a weekly publication from hedgefund.net, Fortress is "Less a pure hedge fund than an alternative asset manager … [the firm] has $24 billion in capital under management, $13 billion of which is private equity money." This is further proof of the ever increasing overlap of hedge funds and private equity investing, both areas where investors allow for greater manager-specific risk in lieu of market-specific risk, although in reality there’s a good dose of both.

So I pose the questions: Do retail investors need these alternative investments? Should they be getting into these instruments?

Let’s be honest here. This is a question in the minds of almost all investors considering the low return both in equities and fixed income that many consider us to be in for the next decade. Many institutions have or are going through this sort of internal debate. Others like San Diego County are having a more significant round of discussions due to “event driven” circumstances like the Amaranth blow-up.

I’ll be speaking at a hedge fund conference next week and this is one of the slides I plan on showing (click to enlarge):

There are two hedge fund indices which I use to represent the US hedge fund industry, a somewhat flawed premise but two broad samples nonetheless, along with the S&P 500. Clearly, the hedge fund industry has shown positive correlation with the broad equity market during the bull markets of the 1990s and the past four years. However, during 2000-2002, the hedge fund indices behaved more like a cash position or an equity index with an embedded put option.

So one conclusion that can be made is that, yes, hedge funds seem to perform well in both good and bad markets (they’re absolute return focused versus relative return). However, I believe one must also ask whether, in the big picture, defensive strategies such as an option overlay may provide adequate protection to major market meltdowns so that alternative investments, and the onerous process therein to select these, are deemed unnecessary? If so, then a significant amount of resources (time, money, etc.) can be saved. Or at least, the limiting of actively managed alternative investments/strategies would allow for significant resources to be allocated in just these areas which likely requires more attention than the rather “plain vanilla” long-only traditional investment holdings.

An interesting observation might come from David Swensen of Yale’s endowment fund who I believe follows just this method. His first book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, basically suggested that alternative investments like private equity and hedge funds are the way to go and his performance certainly would back that up. However, he argues that a large fund like his has a very long-term investment horizon that can more adequately deal with issues such as liquidity and costs. His second book, Unconventional Success: A Fundamental Approach to Personal Investment, goes to great lengths arguing that many obstacles facing ordinary private investors set them up for failure. Not only does he not seem to be a big fan of alternative investments for private investors, he argues against mutual funds (specifically, for-profit mutual funds) as a component of the portfolio construction process and instead praises the virtues of exchange traded funds.

Because there is a wide spectrum of private investors with varying degrees of risk tolerance, portfolio size, objectives, etc. it is not sufficient to simply say alternative investments -- let’s be specific and say “private equity and hedge fund investments” -- are either good or bad. This is synonymous to large pension funds that are now discussing whether hedge funds should be included in their overall program. Knee-jerk reaction to funding liability concerns? Possibly, but I hope not. We would hope it is simply a reaction to evidence from the market environment (such as the decreased equity risk premium) that thereby suggests the search for alpha will provide greater assurances of properly funding future liabilities versus a reliance on market index returns.

But what if both highly actively managed strategies as well as inexpensive market returns (buy-hold ETF based strategies) can both not be relied upon in the intermediate term? A somewhat scary commentary from Bill Gross at PIMCO suggests that we are entering a beta and alpha anemic world. I highly recommend this reading although you can also listen to him read the text on his podcast.

A beta and alpha anemic world to me means that a buy-hold index strategy will not perform well, but nor will pure alpha strategies (if that’s what hedge funds and private equity investments are supposed to be).

Ouch!

Lastly, in terms of more reading, I found another recent tie-in related to alternative investments and even a reference to Yale. Jeremy Gratham of GMO LLC has some interesting commentary in their October 2006 quarterly letter:

· “Global markets are being heavily impacted by a tidal wave of diversification, with the cash flow moving predominately from the traditional areas of U.S. blue chips and U.S. government bonds into more esoteric areas. In fact the more exotic the better.”

· “This change has run into the comparative illiquidity of many new areas such as timber, infrastructure, emerging markets, and some specialized hedge fund strategies, and has moved prices up rapidly. This has reduced or eliminated the large gaps between the pricing of alternative and that of more traditional assets. Indeed, in some cases like private equity, it seems likely to have produced extreme overpricing.”

Gratham goes on to mention how the total fees paid into the investment industry has grown with the shift of focus to hedge funds and private equity related products. This has attracted talent with the effect that “finding value is harder, and even when found, it is spread thinner over more capital”. It is then no surprise that his next comment is in regard to the use of leverage by managers in the hope of maintaining past performance. His conclusion is just about as ominous as that from Bill Gross:

“The new flows into diversifying areas show no sigh of abating despite higher prices and a ridiculously small risk premium. As such, we must assume that several areas will be pushed deep into bubble territory and will eventually burst.”

It’s no wonder that GMO’s quarterly report is titled “Oh, Brave New World I” with the introductory section summarized above subtitled as “Let’s All Look Like Yale”.

So, let’s circle back to the world of ETFs and their transition away from classic market cap weighted indexation, into not only diverging methods of indexing but also a move to the broadly defined “alternative investments”. On the one hand, ETFs that allow ordinary investors into new areas and provide some, but likely not all, of the positive attributes associated with them, would seem to be the best of both worlds as described in David Swensen’s two books. A complete investment program including the use of alternatives seems to be the ideal solution for private investors, even with the possibility of using ETFs and closed end funds as the means for implementation. If this were the case, then the remaining problem would be boiled down to simple risk/asset allocation, although I think it’s rather naïve to call the allocation process “simple”. Case in point: Is now the time to add significant allocations to hedge funds and private equity?

For the investor who thinks the answer is yes and has the time/inclination to study this area, an added selection process could be built to decide what managers/products to add to the mix. Not an easy thing by any means. For the vast majority of individual investors, I would say no. For the do-it-yourselfer, there are numerous defensive strategies that can be applied on top of a well diversified portfolio including sector rotation, option strategies, inverse ETFs (or shorting futures), as well as simply moving assets to cash.

Bottom line: Hedge funds and private equity investing for the ordinary investor are apples. Hedge funds and private equity investing for the large institutional investors are oranges. Although the fact that institutions like Yale are significantly invested in this space, and this would lead many to believe that the appropriateness of these investments can apply to anyone, the problem is in the implementation. A favorable fee structure is just one thing that large institutions can “strong arm” from managers.

Already we are seeing the trend being extended to institutions having increased transparency and redemption allowances. In aggregate, individual investors simply don’t have access to alternative managers in the same context to allow for such conditions. The ETF/CEF expansion in this space could be an answer, but it’s just too early to move significant monies into these. We need more competition in this space, if not for the better attributes just mentioned above, then simply for more choice among available talent.

Comments

[testguy:]

The following comments are from the 9/06 issus of IndexInvestor.com
______________________...


Private Equity Index Fund Registered

We all knew it would eventually happen. And now it has. In early August, Powershares registered with the U.S. Securities and Exchange Commission a new "index fund" that will track the yet to be finalized "Red Rocks Listed Private Equity Index." Said "index" will include "stocks of securities and American depositary receipts ("ADRs") of approximately [_] publicly listed private equity companies, including business development companies ("BDC") and other financial institutions or vehicles whose principal business is to invest in and lend capital to privately-held companies (collectively "listed private equity companies")." Let's put it this way: we're not going to rush out to invest in this ETF when it is launched. Why not? Because on average, the returns from investing in private equity are no higher than those from investing in a broad public equity market index. But this average hides a more important fact: most positive private equity returns are earned by the top quartile of private equity managers - the rest earn far less.

Two recent research papers highlight why this is the case. In "Divisional Reverse Leveraged Buyouts: Finishing School or Financial Arbitrage?", Braun and Sharma compare a matched sample of divisions that were spun off by their parent companies via initial public offerings, to those which first go through an LBO before being IPO'd. They observe the latter outperform the former, and ask why this is so. They find that the LBO'd divisions start out with relatively superior operating performance, which remains unchanged while they are privately owned. The authors therefore conclude that the key driver of the superior IPO performance of the LBO'd divisions is superior deal selection and negotiation by private equity managers (in essence, their ability to buy the division from its owners for less than it is worth) rather than their ability to improve its operations before it is IPO'd. In another paper, "The Performance of Reverse Leveraged Buyouts", Cao and Lerner analyze 496 buyouts that were IPO'd between 1980 and 2002. They find much of the outperformance of these IPOs is concentrated in the larger deals. In the context of the soon-to-be-launched private equity "index" ETF, these studies raise a simple question: What are the chances that the relatively few private equity funds that will generate most of the returns from future buyout deals are going to be among those included in the index? In our view, the answer lies somewhere between slim and none.

Three Interesting New Hedge Fund Studies

We recently read three fascinating new studies of hedge fund performance. In "Hedge Funds: Performance, Risk and Capital Formation", Fung, Hsieh, Naik and Ramadorai study an extremely comprehensive database covering the performance 1,603 funds of funds between 1995 and 2004. They study funds of funds rather than individual hedge funds, because in today's environment more and more money is invested in hedge funds via this indirect route. Unsurprisingly, the authors find that there are significant differences across FOF's in terms of their ability to generate alpha for their investors. They also find differences among investors themselves, with some apparently skilled at identifying alpha generating FOFs, while others seem to simply chase returns, with no apparent skill at identifying alpha generators. Yet, like Berk and Green before them (in their famous paper, "Mutual Fund Flows and Performance in Rational Markets"), Fung, Hsieh, Naik and Ramadorai also find that in the hedge fund world, good times don't last. Funds that generate alpha receive larger inflows of new investment, which is associated with a decline in their future alphas. The authors conclude that their "findings suggest that there is an apparent mismatch between the supply and demand for alpha. On the one hand, capital appears to be seeking alpha. On the other hand, the supply of alpha appears to be drying up."

In "A Portrait of Hedge Fund Investors: Flows, Performance and Smart Money", Baquero and Verbeek shed more light on the behavior of hedge fund investors by separating their investment and divestment decisions. Specifically, outflows take place relatively quickly, based on quarterly performance, while inflows are more closely linked to annual performance. The authors speculate that the former phenomenon may lead underperforming hedge fund managers to take on excessive risk to avoid losing assets. They also speculate that the slow pace of inflows may lead to investor overconfidence about hedge fund manager skills, as it leads to apparent performance persistence at the quarter-to-quarter time horizon. The authors show that this confidence is not warranted, as on average hedge funds receiving substantial inflows tend to underperform their respective style indexes.

Finally, in "Can Hedge Fund Returns Be Replicated: The Linear Case", Hasanhodzic and Lo analyze the extent to which different hedge fund style returns can be replicated using linear combinations of six tradeable instruments: the U.S. dollar index futures, intermediate terms corporate AA rated bonds, the credit spread between BBB rated corporate bonds and U.S. treasury bonds, the S&P 500, GSCI, and VIX. Put differently, the authors attempt to replicate hedge fund returns using different combinations of stock, bond, credit, currency, commodity, and volatility risk. While full replication of hedge fund results proves impossible (due to the presence of alpha), the results the authors achieve will probably come as a surprise to many investors. Put another way, Hasanhodzic and Lo show that a surprisingly high proportion of hedge fund returns come not from alpha (i.e., exposure to unsystematic risk and manager skill), but rather from exposure to systematic risk (beta). This is not good news if you are paying 2% of the assets and 20% of the profits to a hedge fund manager, and perhaps another layer of fees to a fund-of-funds manager on top of that.

2006 Nov 06 11:59 AM

[testguy:]

To SeekingAlpha: If you guys think my last post probably violates the copywright, pls. delete it.

2006 Nov 06 12:03 PM

[Charlie Str...:]

A press release says that Fortress Investment Group will be listed under the symbol FIG and that they manage hedge fund money, private equity and "publicly traded alternative investment vehicles". Do you know anything about these vehicles? To see other hedge fund groups that have listed check out OCX on the Toronto exchange and EMG on the London exchange.

2006 Nov 10 06:40 PM

[Richard Kang1:]

In Toronto, there's a well known fund-of-hedge fund company whose focus is mainly on institutional investors. However, they do have a few exchange traded vehicles. Here are some links for bigcharts.com:

bigcharts.marketwatch....

bigcharts.marketwatch....

Nearly 9% yield in both cases which is a nice benefit. This type of instrument (exchange traded hedge fund vehicle) is in its earliest stages. It needs to expand and with increased competition will become further innovation and more rosbust product development.

Until then, might be wise to wait and see. The charts show these have fairly thin trading in both cases. Benefits of liquidity in exchange traded instrument are offset by this low volume (at least if we're talking significant assets).

In the US, you have to wonder if this will have legs. What hedge fund manager will want to be burdened by the added regulatory requirements placed on publicly traded instruments (Sarbanes-Oxley, etc.)? This is equally true for private equity managers.

2006 Nov 11 03:26 PM

[Charlie Str...:]

If you're interested the FIG website says that the publicly traded vehicles or "castles" invest primarily in real estate:

www.fortressinv.com

2006 Nov 16 03:59 PM