2007 Global Custodian Prime Brokerage Survey

The results of the 14th Global Custodian Prime Brokerage Survey have been released by Global Custodian, a magazine that covers international securities services businesses. A total of 2,826 responses were received in relation to 23 prime brokerage firms, of which 15 had sufficient responses to be rated.

The top rating globally was received by Morgan Stanley, followed by Deutsche Bank and Bear Sterns. More relevant to Australian hedge funds is the rating in Asia (ex Japan) where Deutsche Bank headed the table followed by UBS and Morgan Stanley. Other rated prime brokers in Asia (ex Japan) were Goldman Sachs, Merrill Lynch, Lehman Brothers and Credit Suisse.

Highly rated Morgan Stanley had some below average ratings in reporting and securities lending, while Deutsche Bank scored below average in some areas of reporting and technology. Both had strong results in client service.

55 questions were asked across nine service areas including:

• client service
• operations
• hedge fund business consulting services
• financing
• securities lending
• reporting
• capital introductions
• technology, and
  
• value

Results were grouped by different sized clients (less than $100 million, $100 million - $1 billion and over $1 billion).

To achieve a top rated service or top rated regional provider required was not too hard a hurdle as it required achieving an overall weighted average score that was equal to or better than the average score for that service or region.

Hedge Fund Conference Presenter Arrested After Visit to Australia

According the hedge fund newsletter publisher Hedgeweek, the founder, Managing Director and Chief Investment Officer at US hedge fund Anchor Point Capital LLC, Albert Hsu, was arrested on 2 March 2007 and charged with attempted kidnapping and sexual assault. According to the New York Post he was arraigned in the Superior Court in Norwalk Connecticut, and set a bail of $1,000,000.

Mr Hsu was Chairman and Special Address speaker at Day 2 of the 8th annual Hedge Funds World Australia 2007 Conference in Sydney on 1 March 2007, the day before his arrest. Mr Hsu's presentation was mentioned in an earlier post on this blog covering the Hedge Fund World Conference.

Hedgeweek subsequently reported that Anchor Point Capital LLC has told investors it no longer employs Albert Hsu. "Albert would not be able to carry out his business duties and, therefore, is no longer an employee of the firm,'' according to a March 7 letter sent to clients by Timothy Crowe, chief executive officer of Florida-based Anchor Point. Crowe and Hsu started the firm in June 2005.

Deloitte Hedge Fund Survey

Accounting firms are muscling up for market share in the growing hedge fund industry. Last week Ernst & Young were voted best (hedge fund) accounting firm by the influential Hedge Fund Journal, following the hedge fund symposium they road showed globally earlier in the year.

Now Deloitte, in conjunction with Hedge Fund Research, have issued a research study focused on Risk Management titled "Precautions that Pay Off - Risk Management and Valuation Practices in the Global Hedge Fund Industry." The study was based on 60 mostly US-based groups managing about 244 hedge funds. The survey covered a wide range of hedge fund strategies and hedge fund sizes.

Deloitte conclude that the growing hedge fund industry needs to improve its management of risk. Deloitte said many hedge fund groups - which typically follow more aggressive investment strategies - lacked best practice guidelines, such as independent asset valuation or external administrators.

Deloitte raise the concern that the rapid growth of hedge funds (20% pa over the period from 1995 to 2006) had made it difficult to find "excess returns" and that some hedge funds had adopted higher leverage to meet return expectations and thus required tougher risk management. As noted in the EY symposium, the rise of the institutional investor will act to improve hedge fund risk management. Regulators - concerned to avoid systemic risk - are also watching leverage. The RBA's concerns were covered in an earlier blog on this site titled Reserve Bank of Australia's Stevens Flags Australian Hedge Fund Risk.

A key thread in the study is concern about liquidity and valuation. While these are important matters they tend to relate to the minority of strategies; the majority of hedge funds invest in equity long short or market neutral where investments are made in listed markets. In this sense, liquidity and valuation are more of a concern for private equity funds than they are for hedge funds. In Australia, retail funds are required to meet disclosure standards that should deal with these concerns.

Deloitte found that 78% of respondents used an administrator to calculate NAV and 47% used independent third party pricing. However, it's the intersection of these two that is key - how many funds rely on internal pricing of "hard to value securities" - and this is not clear in the study. Fifty seven percent of respondents had valuation committees, although as with third party pricing, these committees have greatest value where hedge funds are taking on the responsbility of pricing "hard to value securities" internally and have less value where investments are exchange listed and valued by the fund's administrator.

Thus, the emphasis on valuation risks in the study may not be justified as for the 22% of respondents that calculated NAV in-house, no measure of "hard to value securities" were attributed and 15 percentage points of this group relied on a separate back office to strike NAV. The 7% of respondents that relied on the fund manager to value is of concern.

A useful framework for a Valuation Policy was provided in the Survey:

1) to the extent practical, establish a pricing function that is independent of the portfolio management function;

2) describe current valuation methodologies and the process for revisions and sign-offs;

3) establish when exceptions to the pricing policy are appropriate, how such exceptions should be authorised, and ensure that exceptions are documented;

4) provide for backtesting and checking the accuracy of the pricing data that are being captured;

5) establish roles and responsibilities of the valuation committee;

6) establish clear governance and controls structure; and

7) be clear to all parties responsible for its application.

The Survey also covered the use of risk management tools. Here great care needs to be taken in interpretting the results. The use of a particular set of metrics may indicate an awareness of risk, but may not be sufficient. For example, a number of prime brokers include risk metrics as part of their offering. Clients of these prime brokers could argue that they employ say a Value at Risk measure without embracing it as part of the investment process of the firm.

Also, different metrics have different usefulness. For example, 50% of respondents apply country concentration limits. However such a metric may not be applicable for example where investments are global in nature and likely to be highly correlated. Amongst the metrics selected, position limits were most highly relied upon (85%) and with justification.

The study included sensible advise in relation to risk governance, including having a written risk management policy, and operational risk.

In summary, Deloitte have made a positive contribution to the hedge fund industry with the publication of their risk management research study. While the emphasis on valuation risks in the study may not be justified, the authors offer some good advice on improving hedge fund risk management governance.

New Performance Survey of Australian Absolute Return (Hedge) Funds

The Investment & Technology magazine has published a new performance survey of absolute return (hedge) funds in its 26 March 2007 Issue. The survey has been prepared in association with Standard & Poors, and provides some more colour to participants in the Australian hedge fund industry. The survey shows returns over various periods to 31 December 2006 and two measures of exposure - net exposure (longs - shorts) and gross exposure (longs + shorts). There are 63 funds listed across 30 different managers.

The survey splits single manager funds from fund of funds and bases the classification on the CSFB/Tremont hedge fund strategies adopted in their popular global hedge fund survey. There was some adaption of the strategies such as combining equity based strategies in one grouping.

This survey suffers a little from teething problems around the definition of net and gross exposure (4 funds show net exposure greater than gross exposure) and the 3 year return data where some funds appear to report non-annualised returns while the balance of funds reported annualised returns. One manager showed pre-fee returns which makes comparison difficult. But all these matters are expected to be rectified in future editions which are now expected on a monthly basis.

Focusing on the 1 years returns (post-fee except for one manager) which are likely to be accurate, there is a marked difference in the outcome for single manager funds compared with fund of funds. The median single manager return over the year to 31 December 2006 was 16.8% compared with fund of funds which had a median post-fee return of 10.2% over the same period.

While the returns posted in the survey are good, care needs to be taken to understand the risk taken in delivering these returns - have they been achieved with either net equity market exposure or substantial leverage? Putting aside the data difficulties noted above, it would appear that leverage (as measured by gross exposure) is not particularly high. A typical equity based fund has a long position less than 100% partially offset with a lesser short position.

However, it is the net exposure which may explain a significant part of the return in 2006 and will carry risk in a down market. This is a matter that Peter Smith at van Eyk is expected to focus on in a forthcoming analysis of alpha and beta in Australian hedge funds. Net exposure amongst single manager multi strategy and equity based funds (excluding the 4 funds where net exposure is reported as being higher than gross exposure), where there is a reasonable sample size of 20, was reported as 69% at 31 December 2006. Only 4 funds in the survey appeared to be adopting a market neutral approach (including the TI Intercept Capital Fund with which I am associated). This suggests that the equity based absolute return funds listed in the survey will exhibit positive correlation with the relevant equity market in which they are investing.

Next month the Survey will also include some comparatives with hedge fund index returns.

This Survey is another step towards providing more transparency to absolute return (hedge) funds offered to Australian investors and is to be applauded. It suggests that most funds are operating with limited leverage, although high net exposure to equity markets is a concern for investors looking for portfolio diversification from their hedge fund investment.

Hedge Fund World Australia 2007

The number of attendees on day 1 was down on previous years, presumably as a result of the overnight volatility in global sharemarkets that followed the 9% fall in Shanghai the previous day. Day 2 numbers recovered.

The subject matter at the conference is quite diverse and not having attended all sessions it was difficult to extract the key themes. Nevertheless some interesting points were discussed which are summarised below:

1. Retail Investors
The panel members discussing retail interest in hedge funds had long historys of using hedge funds for HNW investors - diversified hedge funds as a bond substitute and long/short equity as a defensive equity component of portfolio. Allocations were in the order of 10/15% of portfolio. The proliferation of 130/30, 120/20 funds were noted with only mderate enthusiasm, including in later panels. While not positioned as a hedge fund there were many references to Platinum as a leader in introducing short selling to retail investors.

Risk in hedge funds is notoriously difficult to explain to retail investors. Volatility is a proxy for risk, but risk also needs to be explained in terms of net exposure or other measures of leverage. Importantly, risk and other notions specific to hedge funds need to be explained in simple uncomplicated ways, preferably by way of examples.

The main difficulties advisors have with hedge funds are lack of transparency, poor liquidity and for offshore products, FIF. Most popular strategies are equity long/short, including market neutral.

2. Institutional Investors

The two institutional panelists, Frances Magill (Statewide Super) and Robin Burns (Equipsuper) provided a sharp contrast to the retail panel with their lack of commitment to hedge funds. Both had very low weightings to hedge funds (less than 1%?) that were introduced as "toes in the water" and in the case of Statewide was likely to cut the position on the advice of their asset consultant Access Economics. Frances and Robin acknowledged their governance structures inhibited their hedge fund appetite. Also concerns were also raised about fees, transparency, the research effort in identifying attractive strategies/managers and the difficulty in explaining to trustees, especially if something went wrong. It is far easier to explain a failed investment in a toll road for example, than a failed investment in a hedge fund.

This approach to hedge funds doesn't appear to be representative of Australian institutional investors generally, although the concerns raised will likely impact all institutional investors. A Jan 2006 survey conducted by the University of NSW and the Australian chapter of AIMA suggested institutional investors are looking to increase their weight to hedge funds from under 3% to over 4% over the next 2 - 5 years. This survey was discussed in an earlier post on this blog titled "Australian Superannuation Funds Use of Hedge Funds".

A high profile exception in Australia is ARIA ( the new name for the PSS/CSS schemes) that has 15% invested in equity market neutral and market neutral hedge funds, both fund of funds and direct investments. Ephraim Grunhard explained the ARIA approach at an Ernst&Young event in January this year; a summary titled Ernst & Young Hedge Fund Symposium is posted on this blog.

By contrast, in the US where pension fund regulation (ERISA - Employee Retirement Income Security Act) is more onerous than in Australia, hedge fund allocations are generally higher than in Australia; 7.7% in 2005 projected to rise to 9.1% by 2007. Endowments and foundations have been particularly big supporters; 13% in 2005. The high profile Yale and Harvard endowment funds have been remarkably successful which has encouraged others to try and emulate their success.

Investor approaches that are best suited to hedge funds have a low cost passive base with a range of higher priced active strategies, including hedge funds.

The institutional side was also represented in an earlier panel by Tim Hughes (Catholic Superannuation Fund) and Tim Unger (Watson Wyatt). There was concern raised about the beta that is delivered by hedge funds, but general support for funds that delivered uncorrelated after fee returns. While also raising fees as an issue, it was acknowledged that the higher fees attracted talent and thus the prospect of better returns than for lower fee products. One panel member encouraged investors to count their returns rather than the manager's fees.

3. Replication Strategies
While there is a growing number of proponents of hedge fund replication strategies, these seemed to find little interest among panel members and amongst audience members in the refreshment break discussions. At best the replication seeks to track the beta mix of hedge fund strategies with unremarkable returns. Of course, investors are seeking to identify the alpha producers and deliver higher returns than this.

4. Hedge Fund Returns & Fees

A number of speakers raised the issue of investment returns. Recent returns are lower than in the past. Quoting David Hsieh of Duke University, Albert Hsu of Anchor Point Capital put it down to a fixed amount of available alpha being shared by a larger number of hedge funds. This may have the effect of eventually slowing hedge fund growth, although why available alpha should be fixed as markets grow is not clear.

The job is particularly tough for fund of funds that have the additional layer of fees. Fund of funds delivered 6-8% with 2% volatility in 2006. While the low volatility is attractive, the returns are below expectations. When hedge fund returns are lower than equity returns, fees come into question.

Morgan Stanley research in 2006 indicated average fees of 2% management fee and 20% performance fee ie 2+20. The swing towards institutional investors with more buying power will likely have an effect on reducing fees, although for many hedge fund businesses the emphasis is on delivering returns (and receiving performance fees) rather than simply gathering new funds which may have the effect of dampening investment returns. In the near term, successful firms will demand and receive high fees. If net returns are high and are not correlated with sharemarkets, then both manager and investor will be satisfied.

5. Hedge Fund Incubation and Seeding

There is a continual flow of new manager teams with ambitions to be a hedge fund. When these groups present they usually do so with a stellar, albeit short, investment track record and seeders have the challenge of determining what is luck and what is skill. Most prospective start-ups are poorly equipped on the business management side, with limited infrastructure and thus high operational risks.

The two main economic models for seeding are equity and share of economics. The latter is typically more popular because it is less complex and does not require so much involvement and overview of the hedge fund by the seeder.

Richard Keary, whose departure from BT Funds Management coincided with the conference, was of the view that it was simpler to take a view of a manager without a track record and early in the development of the fund.

The panel cautioned potential start-ups to be sure to have sufficient capital to survive the early period of low funds under management. Capital of $500,000 - $1,000,000 may be required to ensure viability. FUM of $50 million is a level from which to build a business, but without a track record of at least 36 mths it would be difficult to attract interest.