The Wave of the Future
17
The Wave of the Future THE 2005 NASRA ANNUAL CONFERENCE A CASE FOR HEDGE FUND INVESTING Sunday, August 7, 2005 7700 Bonhomme Avenue, Suite 300 St. Louis, Missouri 63105 314/727-7211 Stephen P. Holmes, CFA, President Summit Strategies Group
Transcript of The Wave of the Future
The Wave of the Future
THE 2005 NASRA ANNUAL CONFERENCE
A CASE FORHEDGE FUND INVESTING
A CASE FORHEDGE FUND INVESTING
Sunday, August 7, 2005
7700 Bonhomme Avenue, Suite 300St. Louis, Missouri 63105
314/727-7211
Stephen P. Holmes, CFA, PresidentSummit Strategies Group
2Summit Strategies Group
HEDGE FUNDRoles in Portfolio Construction
Provides diversification to a traditional fixed income portfolio in a rising interest rate environment.
Primarily non-directional strategies (relative value and event driven) with the objective of seeking consistent positive absolute returns.
Optimal Strategies included in this portfolio have low correlation to changes in interest rates.
Expected Return: 6-7%%
Expected Standard Deviation: 4-6%
Summit recommends hedge funds be utilized in two roles as portfolio risk management tools in the context of total portfolio construction:
FIXED INCOME ALTERNATIVE
3Summit Strategies Group
HEDGE FUNDRoles in Portfolio Construction
The beta exposure from any portion of the portfolio (equity or fixed income) can be achieved synthetically and combined with the alpha generated by the hedge fund pool.
Allows investors to incorporate the alpha generated by a diversified portfolio of hedge funds with the returns of traditional asset classes.
The objective of the alpha pool is to generate consistent positive returns with minimum drawdowns in order to earn a spread over the beta exposure.
Expected Alpha: 3-4%
Expected Standard Deviation: 3-5%
• Superior Sharpe ratio to a traditional diversified active manager pool
(continued)
PORTABLE ALPHA
4Summit Strategies Group
HEDGEFUNDS
LONG-ONLY ACTIVE MANAGEMENT
ONGOING SOURCES OF RETURNS
Issue Selection(Incremental bets vs. benchmark)+
Less Fees– Less Fees–
Issue Selection & De-Selection+
Latitude of Opportunity Set+Financial “Engineering”+
Leverage+
5Summit Strategies Group
FIXED INCOME DIVERSIFIER
Expected Return: 7.0% 6.0%
PortfolioWeight
Expected Total Return
Standard Deviation
40% 5.0% 6.0%Equity Market Neutral
40% 8.0% 8.0%Multi-Strategy
20% 9.0% 10.0%Directional Strategies
Low HighRisk Spectrum
HEDGE FUND STRATEGIESHEDGE FUND STRATEGIES
Relative ValueRelative Value Event- DrivenEvent- Driven Directional Directional
Equity Market NeutralEquity Market Neutral
Convertible ArbitrageConvertible Arbitrage
Fixed Income ArbitrageFixed Income Arbitrage
Merger ArbitrageMerger Arbitrage
Distressed SecuritiesDistressed Securities
Long/Short EquityLong/Short Equity
Short BiasedShort Biased
MacroMacro
6Summit Strategies Group
PORTABLE ALPHA
HEDGE FUND STRATEGIESHEDGE FUND STRATEGIES
Relative ValueRelative Value Event- DrivenEvent- Driven Directional Directional
Equity Market NeutralEquity Market Neutral
Convertible ArbitrageConvertible Arbitrage
Fixed Income ArbitrageFixed Income Arbitrage
Merger ArbitrageMerger Arbitrage
Distressed SecuritiesDistressed Securities
Long/Short EquityLong/Short Equity
Short BiasedShort Biased
MacroMacro
Expected Return: 3.5% 3.2%
PortfolioWeight
Expected Total Return less LIBOR
Standard Deviation
50% 2.0% 3.0%Equity Market Neutral
50% 5.0% 5.0%Multi-Strategy
7Summit Strategies Group
FIXED INCOME DIVERSIFIERClient Example
Expected return of 6.5% to 7.0% vs. Lehman Aggregate expected return of 4.5%
Fixed income-like volatility
Low correlation to interest rates
-2%
0%
2%
4%
6%
8%
10%
12%
14%
2002* 2003 2004 2005 YTD
Hedge Funds Core Plus Fixed Income
(1.18%)
6.32%
11.44%
8.84%
6.65% 6.75%
0.66%
3.00%
Risk/Return AnalysisSince Hedge Fund Inception
5%
6%
7%
8%
9%
2% 3% 4% 5% 6% 7%Risk (Standard Deviation)
An
nu
aliz
ed R
OR
LB Agg.
Core-Plus
Total Fixed
Core Plus
Total Fixed
LB Aggregate
Median
Core Fixed Universe, 3 Years Ending 6/30/2005
8Summit Strategies Group
PORTABLE ALPHAClient Example
Return and volatility assumptions:
Based on return and volatility expectations, the data suggests an equal-weighted portfolio to deliver alpha of 5.5% with tracking error of 5.4% over a full market cycle
*Volatility and correlations for the managers have been lower than we expect to see in the future
Multi-StrategyFund of Funds
Direct Market Neutral Fund
MarketNeutral Fund of Funds
Market Neutral Fund of Funds
Direct Multi-
Direct Multi-Strategy Fund
-Strategy
Fund
-
ManagerPortfolioWeight
ExpectedTot Ret
– LIBOR StdDev
Direct Multi-Strategy Fund 17% 9% 12%Direct Multi-Strategy Fund 17% 3% 6%
Multi Strategy Fund of Funds 17% 6% 7%Direct Market Neutral Fund 17% 6% 3%Market Neutral Fund of Funds 17% 5% 4%Market Neutral Fund of Funds 17% 4% 4%
5.5% 5.4%
For conservative reasons, we model 4.0%, with 4.0% standard deviation expectation
9Summit Strategies Group
Level of Over/Under Performance vs. Russell 1000Over Three-Year Rolling Periods
-4%
-2%
0%
2%
4%
6%
8%
10%
Dec
-81
Dec
-82
Dec
-83
Dec
-84
Dec
-85
Dec
-86
Dec
-87
Dec
-88
Dec
-89
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
Actual Average
Average: 1.3%
Large Cap Excess ReturnLevel of Over/Under Performance vs. S&P 500 Index
Over Three-Year Rolling Periods
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
Ma
r-8
3
Ma
r-8
4
Ma
r-8
5
Ma
r-8
6
Ma
r-8
7
Ma
r-8
8
Ma
r-8
9
Ma
r-9
0
Ma
r-9
1
Ma
r-9
2
Ma
r-9
3
Ma
r-9
4
Ma
r-9
5
Ma
r-9
6
Ma
r-9
7
Ma
r-9
8
Ma
r-9
9
Ma
r-0
0
Ma
r-0
1
Ma
r-0
2
Ma
r-0
3
Ma
r-0
4
Top Quartile Median Bottom Quartile
Avg Top Quartile: 2.9%Avg Median: 0.8%Avg Bottom Quartile: -1.0%
Large Cap Excess Return
Level of Over/Under Performance vs. Russell 2000 IndexOver Three-Year Rolling Periods
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Ma
r-8
3
Ma
r-8
4
Ma
r-8
5
Ma
r-8
6
Ma
r-8
7
Ma
r-8
8
Ma
r-8
9
Ma
r-9
0
Ma
r-9
1
Ma
r-9
2
Ma
r-9
3
Ma
r-9
4
Ma
r-9
5
Ma
r-9
6
Ma
r-9
7
Ma
r-9
8
Ma
r-9
9
Ma
r-0
0
Ma
r-0
1
Ma
r-0
2
Ma
r-0
3
Ma
r-0
4
Top Quartile Median Bottom Quartile
Avg Top Quartile: 6.1% Avg Median: 3.1% Avg Bottom Quartile: 0.4%
Non-Large Cap Excess Return
Actual Actual Client Experience
Non-Large Cap Excess ReturnLevel of Over/Under Performance vs. Russell Mid Cap/Russell 2000
Over Three-Year Rolling Periods
-10%
-5%
0%
5%
10%
15%
Fe
b-8
3
Fe
b-8
4
Fe
b-8
5
Fe
b-8
6
Fe
b-8
7
Fe
b-8
8
Fe
b-8
9
Fe
b-9
0
Fe
b-9
1
Fe
b-9
2
Fe
b-9
3
Fe
b-9
4
Fe
b-9
5
Fe
b-9
6
Fe
b-9
7
Fe
b-9
8
Fe
b-9
9
Fe
b-0
0
Fe
b-0
1
Fe
b-0
2
Fe
b-0
3
Fe
b-0
4
Actual Mid Cap Average Mid Cap Actual Small Cap Average Small Cap
Mid Cap Average: 2.1%
Small Cap Average: 0.5%
CLIENT’S EXCESS RETURN EXPERIENCEby Individual Asset Class
10Summit Strategies Group
Level of Over/Under Performance vs. EAFEOver Three-Year Rolling Periods
-20%
-15%
-10%
-5%
0%
5%
10%
15%
Aug
-86
Aug
-87
Aug
-88
Aug
-89
Aug
-90
Aug
-91
Aug
-92
Aug
-93
Aug
-94
Aug
-95
Aug
-96
Aug
-97
Aug
-98
Aug
-99
Aug
-00
Aug
-01
Aug
-02
Aug
-03
Aug
-04
Actual Average
Average: 1.1%
International Equity Excess ReturnLevel of Over/Under Performance vs. MSCI EAFE Index
Over Three-Year Rolling Periods
-15%
-10%
-5%
0%
5%
10%
15%
20%
Ma
r-8
3
Ma
r-8
4
Ma
r-8
5
Ma
r-8
6
Ma
r-8
7
Ma
r-8
8
Ma
r-8
9
Ma
r-9
0
Ma
r-9
1
Ma
r-9
2
Ma
r-9
3
Ma
r-9
4
Ma
r-9
5
Ma
r-9
6
Ma
r-9
7
Ma
r-9
8
Ma
r-9
9
Ma
r-0
0
Ma
r-0
1
Ma
r-0
2
Ma
r-0
3
Ma
r-0
4
Top Quartile Median Bottom Quartile
Avg Top Quartile: 5.3% Avg Median: 2.0% Avg Bottom Quartile: -0.4%
International Equity Excess Return
Level of Over/Under Performance vs. Lehman AggregateOver Three-Year Rolling Periods
-4%
-3%
-2%
-1%
0%
1%
2%
3%
Se
p-8
5
Se
p-8
6
Se
p-8
7
Se
p-8
8
Se
p-8
9
Se
p-9
0
Se
p-9
1
Se
p-9
2
Se
p-9
3
Se
p-9
4
Se
p-9
5
Se
p-9
6
Se
p-9
7
Se
p-9
8
Se
p-9
9
Se
p-0
0
Se
p-0
1
Se
p-0
2
Se
p-0
3
Actual Average
Average: -0.3%
Fixed Income Excess ReturnLevel of Over/Under Performance vs. LB Aggregate Bond Index (Core +)
Over Three-Year Rolling Periods
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Ma
r-8
3
Ma
r-8
4
Ma
r-8
5
Ma
r-8
6
Ma
r-8
7
Ma
r-8
8
Ma
r-8
9
Ma
r-9
0
Ma
r-9
1
Ma
r-9
2
Ma
r-9
3
Ma
r-9
4
Ma
r-9
5
Ma
r-9
6
Ma
r-9
7
Ma
r-9
8
Ma
r-9
9
Ma
r-0
0
Ma
r-0
1
Ma
r-0
2
Ma
r-0
3
Ma
r-0
4
Top Quartile Median Bottom Quartile
Avg Top Quartile: 1.5%Avg Median: 0.9%Avg Bottom Quartile: -0.3%
Fixed Income Excess Return
Actual Actual Client Experience
CLIENT’S EXCESS RETURN EXPERIENCEby Individual Asset Class (continued)
11Summit Strategies Group
A LOGICAL STARTING POINT TO USE PORTABLE ALPHA
Consider PortableAlpha
DefinitelyUse Portable Alpha
Client's Summit's PortableExperience Expectation Alpha
Large Cap Equity 1.3% 1.0% 4.0%
Non-Large Cap Equity 2.1% 2.5% 4.0%
International 1.1% 3.0% 4.0%
Fixed Income -0.3% 0.5% 4.0%
Client's Summit's PortableExperience Expectation Alpha
Large Cap Equity 1.3% 1.0% 4.0%
Non-Large Cap Equity 2.1% 2.5% 4.0%
International 1.1% 3.0% 4.0%
Fixed Income -0.3% 0.5% 4.0%
VALUE-ADDED (ALPHA)
12Summit Strategies Group
Total Fund ActualLevel of Over/Under Performance vs. Policy Index
Over Three-Year Rolling Periods
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Se
p-9
3
Ma
r-9
4
Se
p-9
4
Ma
r-9
5
Se
p-9
5
Ma
r-9
6
Se
p-9
6
Ma
r-9
7
Se
p-9
7
Ma
r-9
8
Se
p-9
8
Ma
r-9
9
Se
p-9
9
Ma
r-0
0
Se
p-0
0
Ma
r-0
1
Se
p-0
1
Ma
r-0
2
Se
p-0
2
Ma
r-0
3
Se
p-0
3
Ma
r-0
4
Actual Average
Average: 1.3%
Total Portfolio: Actual Client ExperienceTotal Fund Actual
Total Fund Universe RankingOver Three-Year Rolling Periods
0
10
20
30
40
50
60
70
80
90
100
Se
p-93
Mar
-94
Se
p-94
Mar
-95
Se
p-95
Mar
-96
Se
p-96
Mar
-97
Se
p-97
Mar
-98
Se
p-98
Mar
-99
Se
p-99
Mar
-00
Se
p-00
Mar
-01
Se
p-01
Mar
-02
Se
p-02
Mar
-03
Se
p-03
Mar
-04
ICC Corporate Universe Rank
Total Fund with Portable AlphaLevel of Over/Under Performance with 400 bps Alpha
Over Three-Year Rolling Periods
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
Se
p-93
Mar
-94
Se
p-94
Mar
-95
Se
p-95
Mar
-96
Se
p-96
Mar
-97
Se
p-97
Mar
-98
Se
p-98
Mar
-99
Se
p-99
Mar
-00
Se
p-00
Mar
-01
Se
p-01
Mar
-02
Se
p-02
Mar
-03
Se
p-03
Mar
-04
Actual
Average: 4.0%
Total Portfolio: Hypothetical 4% Excess Return from Portable AlphaTotal Fund with Portable Alpha
Total Fund Universe RankingOver Three-Year Rolling Periods
0
10
20
30
40
50
60
70
80
90
100
Se
p-9
3
Ma
r-9
4
Se
p-9
4
Ma
r-9
5
Se
p-9
5
Ma
r-9
6
Se
p-9
6
Ma
r-9
7
Se
p-9
7
Ma
r-9
8
Se
p-9
8
Ma
r-9
9
Se
p-9
9
Ma
r-0
0
Se
p-0
0
Ma
r-0
1
Se
p-0
1
Ma
r-0
2
Se
p-0
2
Ma
r-0
3
Se
p-0
3
Ma
r-0
4
ICC Corporate Universe Rank
IMPACT OF PORTABLE ALPHAON TOTAL PORTFOLIO
13Summit Strategies Group
WHERE DO WE GO FROM HERE?
How did we get here?
• Why are fiduciaries throwing billions into an asset class that has no quality defendable track record, too little disclosure, with too much money, chasing too few ideas?
• Either they really like the above characteristics, OR they’re just moving away from something unpleasant.
What’s so active about ACTIVE management? (long only)
• “Our economic forecast shows very strongly that rates will rise 1.5 to 2% next year, therefore we have positioned your portfolio to be 26 hours short of the benchmark duration.”
• “This is our number one-ranked stock idea, so we've double-weighted it to 1.2% of the portfolio (which is 1/3 the weight of GE, but we have to own it at the benchmark weight).”
• Or, as I asked a small cap growth momentum manager in November, 1999, “How can you own a portfolio with a total P/E ratio of 130x?”, and he replied, “I don’t know.”
What I believe about all asset classes . . .
• Investors get too little for too much.• The supply of true investment talent is much smaller than the industry assumes.
Genius is rare!• Any time large fees are predicated on vast future returns, check your wallet.• Customers create markets in the long run.
14Summit Strategies Group
HOW WE GOT HERE . . .
The customer heard the following from active managers:
• 1995-1999– No way can we keep up with a cap-weighted benchmark; however, if we get a broad market or,
even better, a down market, watch the genius come out!• 2000-2003
– Because of our strict adherence to the benchmark, when the Russell 2000 Growth Index was down 75%, we were only down 71%!
– We all blindly sailed your ship, Mr. Investor, into the same iceberg, but since my boat sank slower than the other boats, then I must be a great captain.
Into the fray steps the hedge fund manager who says:
• “I’ll think with your money.”• “I’ll be my own person.”• “I’m going to charge more but at least I’ll do something!”• For a while it worked
– Markets played into hedge funds’ hands• Being short anything helped relative to long only managers
– Strong relative returns came in• Clients got wealthier• Hedge fund managers got fabulously wealthy
15Summit Strategies Group
WHERE DO WE GO NOW?
Traditional investment managers will look to remove benchmark constraints from portfolios in order to generate “alpha”
Clients will demand more active management from managers
NOT-SO-ACTIVEMANAGEMENT
Active Management
IN THE BEGINNING . . .
PASSIVEMANAGEMENT
“If you’re not going to think, I’m not going to pay you not to think.”
STEP 1
ALPHA TILTS,ENHANCED INDEX
STEP 2 HYPER-ACTIVEMANAGEMENT
“I don’t care what I pay you as long as you deliver.”
Hedge Funds
STEP 3
16Summit Strategies Group
WHAT WE’RE SEEING . . .
Real World Examples:• Western, BlackRock offering long only products with allocations that are not tied to a benchmark• Freeman Associates offering long/short products in order to capture additional alpha from shorting
securities, at flat asset-based fee (no carry)• Maverick Capital launching long only products to provide investors with an alternative to traditional active
management that is less index sensitive• MOSERS using portable alpha structures in order to separate the alpha/beta decision in their portfolio
– Take steps to generate additional “alpha” in more efficient areas of the portfolio• Clients building their own portfolios of direct hedge funds to lower the overall expense of implementation
NOT-SO-ACTIVEMANAGEMENT
HYPER-ACTIVEMANAGEMENT
PASSIVEMANAGEMENT
ALPHA TILTS,ENHANCED INDEX
Morethinking
• Lower fees• Greater
transparency
NEW BREED OFACTIVE MANAGEMENT
17Summit Strategies Group
ACTIVE MANAGEMENT EXAMPLESWestern Absolute Return Fixed Income Portfolio
The Lehman Aggregate Index is the most commonly used proxy for the U.S. “Core” fixed income market
In order to beat the benchmark, the portfolio must be different from the benchmark
• Any position different from the benchmark is a “bet” which will ultimately be right or wrong
• All “bets” are relative to the benchmark; e.g., over or underweighting issues, sectors or duration
Managers do not take big “bets” with traditional core fixed income portfolios – why not?
• Business risk Inconsistent with the asset class philosophy of stability of
principal and income generation In 2004, Summit asked Western and BlackRock to construct
portfolios of their “best ideas,” unconstrained in terms of sector allocation and duration. Target return = LIBOR + 2.5%.
The end product was a portfolio much different from traditional core or core plus mandates
Lehman Brothers Aggregate Bond Index
Cash 0%
Agencies15%
Corporates 20%
CMBS 3%ABS 1%
MBS35%
`
U.S.Treasuries26%
Western Asset Management Absolute Return Portfolio
Cash20%
Credit 5%
High Yield10%
Bank Loans20%
Emerging Markets12%
Non-Dollar10%
Global Inflation Linked
3%
TIPS18%
ABS 2%
