* Hedge Fund Matrix Launched

In a project which brings together some of the world's leading hedge fund and financial markets bodies, today marks the launch of the Hedge Fund Matrix--a user-friendly Web site that offers the first step towards harmonization between existing sound practice guidelines.

The Alternative Investment Management Association, the Hedge Fund Standards Board, the International Organization of Securities Commissions, the Managed Funds Association and the Asset Managers' Committee of the U.S. president's Working Group on Financial Markets have brought together their respective works on hedge fund sound practices for the benefit of the industry and other users.

Many of the core principles in existing sound practice guidelines are similar and now, using the Hedge Fund Matrix, users will be able to compare the various guidelines, side-by-side.

The Matrix includes information on: creating and managing a hedge fund management business; the investment process and portfolio risk management; portfolio administration and operationalcontrols; raising capital and investor relations; and hedge fund structure and organization.

Freely available to all, the Hedge Fund Matrix provides relevant and insightful information for hedge fund practitioners, investors and the regulatory community, and to all those servicing and providing professional advice to the hedge fund industry.

The Hedge Fund Matrix is located at www.hedgefundmatrix.com.

* Hedge funds add fuel to crisis ?

Hedge funds, the opaque and often vilified investment vehicles that aggressively maximize profits while flying under the radar, are contributing to the turmoil in the equities markets.

Plunging stock prices have wreaked havoc on hedge funds, which employ sophisticated trading strategies and can often profit from market anomalies or a company's demise. September was the second-worst month for hedge funds since the industry group Hedge Fund Research Inc. began tracking their performance in 1990.

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When hedge funds fare poorly, nervous investors withdraw their funds. Redemption requests, as the withdrawals are called, in turn force hedge funds to sell assets — stocks they hold — to raise cash to pay back investors.

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Longo, who also oversees hedge funds for an investment group, estimates that as much as 25 percent of the stock market's recent declines are due to hedge funds selling assets to meet redemption requests.

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The magnitude of hedge fund sell-off is expected to worsen. Ang said it's possible that 20 percent of the estimated $2 trillion in hedge-fund assets could be sold by the year's end.

What's more, Ang said, is once hedge funds – which are heavily leveraged — sell assets, they have to sell more assets to raise cash to reduce their debt load. "This effect might be much larger depending on what the leverages are of these funds," he said.

Investors receive reports on their hedge funds' performances each quarter typically, and usually must request redemptions three months in advance.

The likely losses will reshape the hedge-fund industry. Though the extent of the impact is a matter of debate, many experts agree that the coming months will see the collapse of many of the more than 10,000 hedge funds.

Detail: Hedge funds add fuel to crisis

* Hedge Fund Leverage

HedgeCo.net reports: The Bank for International Settlements in Basel, Switzerland was probably abuzz last week watching history unfold before its eyes. After all, one of the lynchpins of the organization’s Basel II Accord was the requirement for banks to mark-to-market all assets - including less liquid ones. And it appears that doing so in a leveraged environment has put several banks into a death spiral in recent weeks.

But the BIS is also keeping an eye on hedge fund leverage. The organization just released a working paper called “Estimating Hedge Fund Leverage” that proposes a new method of calculating the level of leverage used by hedge funds and, it is hoped, a way to measure any resulting systemic risks to the financial system. Regular readers may remember that this topic was also covered by the Fed’s Tobias Adrian last year.

Detail: http://www.bis.org/publ/work260.pdf

* High Watermark

The highest peak in value that an investment fund/account has reached. This term is often used in the context of fund manager compensation, which is performance based.

The high watermark ensures that the manager does not get paid large sums for poor performance. So if the manager loses money over a period, he or she must get the fund above the high watermark before receiving a performance bonus. For example, say after reaching its peak a fund loses $100,000 in year one, and then makes $250,000 in year two. The manager therefore not only reached the high watermark but exceeded it by $150,000 ($250,000 - $100,000), which is the amount on which the manager gets paid the bonus.

Related words: Crystallize; Equalization; Performance fees

* Side Pocket

A type of account used in hedge funds to separate illiquid assets from other more liquid investments. Once an investment enters a side pocket account, only the present participants in the hedge fund will be entitled to a share of it. Future investors will not receive a share of the proceeds in the event the asset's returns get realized.

Investors who leave the hedge fund will still receive a share of the side pocket's value when it gets realized. Usually only the most illiquid assets, such as delisted shares of a company, receive this type of treatment, because holding illiquid assets in a standard hedge fund portfolio can cause a great deal of complexity when investors liquidate their position. Overall, side pocket accounts resemble single asset private equity funds in structure.

* The benefit of lock-ups

Reuters reports: Hedge fund investors are increasingly demanding longer lock-ups for their money -- a move almost unheard of a few years ago -- as fears of big withdrawals start to outweigh the need to get out of badly-performing funds. While hedge fund performance has been poor this year -- Hedge Fund Research's HFRX Global Hedge Fund index fell 6.9 percent in September, its worst monthly performance on record, taking the year-to-date drop to 11.61 percent -- many investors are more worried about the survival of funds they invest in.

Many fear a rush for the exit door in underperforming funds could hurt those investors who are left by leaving them with less liquid assets, or could force funds to close and give long-term investors their money back at a time when asset prices are low.

In contrast, some investors feel that riding out the credit crisis over the next few years could generate attractive returns. "Some investors want lock-ups so other investors can't get out and destroy the business. We're seeing one-to-three years (lock-ups)," Roberto Cagnati, head of manager selection at Swiss-based Partners Group, told Reuters.

* Alternative Energy ABL Fund

	Alternative Energy ABL Fund Gains Momentum from Credit Crunch
posted on Monday 6 Oct 2008 07:29 BST
While many hedge funds across Wall Street are closing down from rising redemptions and poor performance, one emerging fund has found that the current market turmoil has actually increased investors’ interest in their fund. The Aurarian Capital Clean Energy Asset Based Lending Fund will launch on October 31, 2008. The fund will provide assetbased loans to finance renewable energy power plants and biofuel refineries. Asset-based lending strategies are clear winners in the current market environment due to their lack of correlation to the broader market indices, but the increased attention to the Clean Energy ABL fund can be partially attributed to the credit market collapse. Last week, the Fund signed its first binding term sheet with a biofuels developer for a $78 million investment, with the right to finance three additional plants of increasing size and profitability. The biofuels developer, like many of its peers, was unable to secure credit from traditional lenders due to the ongoing credit crunch. Following a due diligence process, Aurarian was able to step in and fill this “financing gap.” SAC veteran and founder Jason Gold leads the team ensuring proper technology and business model due diligence while co-portfolio manager Kent Larsen leads the team in deal structuring. Although he didn’t reveal all the terms of the deal, Gold indicated that the interest rate Aurarian would receive on the debt would be 20%. Coupled with the additional fees, warrants and Aurarian’s share of the tax credits, the returns would likely be “comfortably north of 20%.” Gold continued, “This deal provides us with over $1 billion of backlog that we’ll be able to fund at very attractive terms. I’m pleased that we will launch with such a profitable set of deals in our arsenal.” “And while we certainly feel badly for those whose businesses have been adversely affected by the constrained credit environment, one positive outcome of this overwhelming negative is that deal-flow for our project finance model has expanded materially. Our experience in proper structuring of these deals made us a lender of preferred resort in the alternative energy industry,” said Gold. Strong governmental and social support behind the clean-energy movement has created a model that investors seem to find compelling, but this is only the beginning. “The demand for this fund has exceeded my most optimistic estimates” said Gold. “An investor scale-back now is likely at the fund’s launch, and our new priority is to partner with the right investors who bring long term strategic significance.”

* Not the problem, but the solution

Hedge Pride - An open Letter to the Financial Times From Simon Ruddick, Managing Director of Albourne
posted on Friday 3 Oct 2008 11:12 BST
Albourne is not a hedge fund, but it helps pension plans, university foundations and charities and the like allocate money to them. We are hugely proud of this work because we are utterly convinced that hedge funds are good for our clients; good for the markets and good for the average man, and woman, in the street. For all our sakes, discussion of the role and impact of hedge funds has to be disentangled from the populist politics of envy. For the record, although it should be completely irrelevant: I have never voted Conservative; I was the first in my family to stay in school after 15 and I am hugely proud of my family’s union roots; I am writing this from our offices, which are juxtaposed between a gas-works and a home for lost dogs. I feel compelled to “stand up and be counted” at this time exactly because it will be the vulnerable in society who end up bearing the brunt of the current meltdown in commonsense, if it continues on its current path. The global credit binge was neither created, nor fuelled, by hedge funds. They are now being vilified for having played a role in bringing this madness to an end. Those investment banks running with 29 times leverage, or building societies lending out radically more money then they had received in deposits, were all fully regulated entities. Did the regulators blow the whistle: or the management or shareholders of those banks; or the journalists; or the politicians? Left unabated, just how much deeper into trouble could this inadvertent conspiracy of ignorance and negligence have got us? There needs to be quite a dark word beyond irony to describe why the FSA has initiated multiple enquiries about short-selling without having initiated a single enquiry directed at the officers of the firms that have actually failed. Even the Archbishop of Canterbury now seems happy to pontificate on short-selling, as if it were an ecumenical issue. Presumably he is also against wasps, rain, MMR jabs and a whole host of other things that appear very irritating to those who have absolutely no concept of how equilibrium within complex systems has to work. For the avoidance of doubt, not a single dollar of tax payer’s money has ever been, nor ever will be, needed to bail out a hedge fund. Indeed, there is already a pool of $700bn waiting to rescue the world’s financial markets: it is called the hedge fund industry. Quite simply, it works because of an alignment of interests. Hedge fund managers put their own money, alongside that of their clients’, exactly where their mouth is. Of course, there will always be some who just find the rich intrinsically unattractive. They should vote for higher taxation. Many may then take that wealth, their taxes, their donations and the business that their consumption creates somewhere else, but at least London’s loss would be some other city’s gain. What would convert a crisis into a tragedy would be to regress to a state-managed economy where rules will always be “gamed” and where corruption fills the vacuum left by honest aligned god-fearing endeavour. Hedge funds are not the problem. They are the solution.

* Hard times for hedge funds

The main reason for the current losses is that many funds’ trading strategies have come unstuck in a “dash for cash”. Among the worst hit funds are those that engage in convertible bond arbitrage and activist funds, which try to shake up the companies in which they hold stakes.

Other factors have added to the funds’ woes. As their losses build, some funds become forced sellers to meet margin calls on loss-making positions. Investment banks that provide financing have retrenched, been taken over or collapsed.

Leverage has become harder to get, making it difficult for hedge funds to generate outsize returns. Regulatory bans on the short-selling of financial stocks have not helped because they have removed an important hedging tool. The demise of Lehman Brothers swallowed the collateral of funds that used it as a prime broker, adding to the strain. Some clients now want to get out.

Detail: FT: Hard times for hedge funds

Also: the industry’s shrinkage does pose dangers. First, the loss of quantitative hedge funds, which provide a large chunk of stock market liquidity, could add to the volatility in markets. Second, many hedge funds act as venture capitalists, providing small companies with funding they might not otherwise be able to access. Several of the biggest and most successful funds are also playing important roles in recapitalising the shattered banking sector. Barclays, the UK bank, relied heavily on hedge funds in a recent capital raising.

* Equilibrium thinking?

An agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

Detail: This Economy Does Not Compute

* Impact of Incentive Fees

Factor models are frequently applied to hedge fund returns in an attempt to separate the return from identified risk factors (beta) and from manager skill (alpha). More recently, these same techniques have been used to replicate the returns from hedge fund strategies with varying degrees of success.

In the following paper, researchers show that due to the particular nature of hedge fund incentive contracts, the use of net of fee returns can lead to considerably biased estimates of factor exposures which can distort the picture of fund manager performance. The solution they propose is to model the gross returns of hedge funds and the incentive fees independently, which gives a truer representation of the underlying return generating process.

Using a large sample of hedge funds, they quantify the effect of this bias on both performance attribution and replication. They find that using net of fee returns understates the return attributable to beta by up to 58 basis points per annum.

Following from this they find that some of the additional beta exposure can be captured by basing replication on gross rather than net returns. They also investigate the risk taking behaviour of fund managers conditional upon the delta of their incentive option and find that contrary to previous studies, there does appear to be evidence of increased risk taking for those managers who find themselves significantly below their high water mark.

Detail: The Gross Truth About Hedge Fund Performance and Risk: The Impact of Incentive Fees

* Emerging Market funds

Hedge funds should be well equipped to take advantage of opportunities in emerging markets due to their flexibility in investment strategy and lockup periods. However, the findings in the following paper show that, at the strategy-level, emerging market hedge funds have only been able to generate risk-adjusted returns in the most recent period when analyzing data between 1994 and 2004.

Also, the strategy in question does not present the investor with any benefits that would be valuable in a hedge fund portfolio. There is weak evidence of persistence in risk-adjusted returns at the fund-level. However, good performance is not rewarded with capital inflows. This reduces incentives for managers to exert effort and may even deter skillful managers from entering the strategy. Consistent with these results, investors have reallocated their money to other hedge fund strategies.

Although emerging market hedge funds have performed poorly in the past, an important finding is the upward trend over time in performance. Given that other hedge fund strategies have a declining trend in alpha, perhaps emerging market funds are where future alphas can be found.

Detail: Should You Invest in Emerging Market Hedge Funds?

* Banks' role

During systematic liquidity shocks, hedge funds are able to borrow from banks and thus are not limited by capital constraints. Government-protected bank deposits receive inflows during systematic liquidity shocks. These inflows provide low cost funding and help estimate the magnitude of a shock, reducing the information asymmetry that constrains hedge funds.

The unique combination of low funding cost and sophisticated information gives banks an advantage in lending to hedge funds. While banks do not participate in the upside risk that they finance, they compete away their effective government subsidy to the benefit of their hedge fund clients.

Detail: Liquidity Risk and Limited Arbitrage: Are Banks Helping Hedge Funds Get Rich?

* Past, Present and Future

Assets managed by hedge funds have grown faster over the last ten years than assets managed by mutual funds. Hedge funds and mutual funds perform the same economic function, but hedge funds are largely unregulated while mutual funds are tightly regulated.

The following paper compares the organization, performance, and risks of hedge funds and mutual funds. It then examines whether one can expect increasing convergence between these two investment vehicles and concludes that the performance gap between hedge funds and mutual funds will narrow, that regulatory developments will limit the flexibility of hedge funds, and that hedge funds will become more institutionalized.

Detail: Hedge Funds: Past, Present and Future

* Last resort?

Hedge funds have become important investors in public companies raising equity privately. Hedge funds tend to finance companies that have poor fundamentals and pronounced informational asymmetries. To compensate for these shortcomings, hedge funds protect themselves by requiring substantial discounts, negotiating repricing rights, and entering into short positions of the underlying stocks.

Researchers find that companies that obtain financing from hedge funds significantly underperform companies that obtain financing from other investors during the following two years. They argue that hedge funds are investors of last resort and provide funding for companies that are otherwise constrained from raising equity capital.

Detail: Hedge Funds as Investors of Last Resort?

* Implications for Financial Stability

The following paper provides an overview of the hedge fund industry, mainly from a financial stability and European angle. It is primarily based on an extensive analysis of information from the TASS database. On the positive side of the financial stability assessment, hedge funds have a role as providers of diversification and liquidity, and they contribute to the integration and completeness of financial markets. Possible negative effects occur through their impact on financial markets (e.g. via crowded trades) and financial institutions (e.g. via prime brokerage).

Several initiatives have been launched to address these concerns and most of them follow indirect regulation via banks. If any direct regulation were to be considered, it would probably have to be implemented in a coordinated manner at the international level. At the EU level there is currently no common regulatory regime, although some Member States have adopted national legislation.

Detail: Hedge Funds and their Implications for Financial Stability

* Multi-factor approach

In contrast to long-only fund management, where investment strategies are often tethered to benchmarks and usually employ linear trading strategies, hedge funds can invest in a vast range of opportunity sets through a wide array of instruments, often employing complex non-linear or levered trading strategies, or potentially illiquid positions. Furthermore, these investment themes and niche opportunities are often turned over on a much more frequent basis, and hence the historic return profile will inevitably lag the changing dynamics of the investment basis.

Accounting for all of the above, it is evident that, relative to long-only strategies, the presence of these additional degrees of freedom in alternative strategies invariably means that traditional, return-analysis based, risk. Compounding matters, this discrepancy is widely understood to be of greatest significance in the extreme downside tail of the prevailing risk profile.

Detail: Hedge fund risk drivers from a fund of funds perspective

* Hedge Fund unique?

By dynamically trading futures in very much the same way as investment banks hedge their OTC option positions it is possible to generate returns that are statistically very similar to the returns generated by hedge funds but without any of the usual drawbacks surrounding alternative investments, i.e. without liquidity, capacity, transparency or style drift problems and without paying over-the-top management fees.

Hedge fund returns may be different, but they are certainly not unique.


Detail: Hedge Fund Returns: You Can Make Them Yourself!

* Due diligence

Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly - or fail - due to operational risk concerns.

However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that researchers document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.

Detail: Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy

* Taking Advantage

This following paper explores the question of whether hedge funds engage in front-running strategies that exploit the predictable trades of others. One potential opportunity for front-running arises when distressed mutual funds - those suffering large outflows of assets under management - are forced to sell stocks they own.

The researchers document two pieces of evidence that are consistent with hedge funds taking advantage of this opportunity. First, in the time series, the average returns of long/short equity hedge funds are significantly higher in those months when a larger fraction of the mutual-fund sector is in distress. Second, at the individual stock level, short interest rises in advance of sales by distressed mutual funds.

Detail: Do Hedge Funds Profit from Mutual-Fund Distress?