Insight into April Hedge Fund Performance/ May Down 1.50%

The Dow Jones Credit Suisse Hedge Fund Index finished down 0.04% in April. A new monthly commentary offers insight into hedge fund performance through the month of April. Some key findings from the report include:

_ Hedge funds, as measured by the Dow Jones Credit Suisse Hedge Fund Index, finished April down 0.04%, with 4 out of 10 strategies in positive territory;

_ In total, the industry saw estimated outflows of approximately $8.35 billion in April, bringing overall assets under management for the industry to approximately $1.75 trillion;

_ The Managed Futures and Multi-Strategy sectors experienced the largest asset inflows on a percentage basis in April, with inflows of 0.53% and 0.14% from March 2012 levels, respectively;

_ Long/Short Equity funds finished down in April, ending a three-month positive performance run, as broader equity benchmarks finished in negative territory for the month; and

_ Global Macro generated negative performance as a whole. Funds commonly reduced risk exposures as macroeconomic data continued to show weakness.

The Dow Jones Credit Suisse Core Hedge Fund Index closed down 1.50% in May as most of the index component strategies reported negative results for May.

eVestment||HFN Industry Research: Hedge Funds Down in May,

Hedge Fund Industry Estimates for May 2012

May 2012 was very similar to September 2011 in that Europe’s sovereign crisis was a primary focus and equity and commodity markets were severely impacted as investors moved to “safer” assets, resulting in U.S. Treasury yields falling and the dollar rising against all major currencies. In that environment FX strategies performed well, and despite being negative, credit led by funds focused on government, securitized assets (primarily mortgages), managed futures and macro strategies all did well on a relative basis. Additionally, larger funds performed noticeably better across the strategy spectrum.

Early reporting funds for May are showing a median return of -0.26%, significantly outpacing the S&P 500 Total Return Index’s -6.01%, however regression estimates for the industry point to a decline of -2.01%.

May performance, as anticipated, appears to have been led by macro and managed futures strategies and funds focused on currency markets. Credit funds have again outperformed equity focused strategies and emerging markets exposure experienced higher losses than developed markets.

With difficult to manage global scenarios persisting into June, it is important to note that recent hedge fund investor flows appear to have been placed well for the current environment. Investor flows through April 2012 indicated that the vast majority of net inflows to the industry have been going to credit, macro and commodity strategies as well as more diversified multi-strategy funds. Investors have pulled a significant amount of assets from long/short equity, event driven and emerging market strategies in 2012.

Citi Survey Shows Investors’ Interest in CTA and Macro Strategies Accelerated Sharply Following 2008 Financial Crisis

Managed Futures increased market share to 14% of combined industry AUM at the end of 2011, up from 10% in 2007

Investors’ attention to Commodity Trading Advisors (CTAs) and to currency focused Macro hedge funds accelerated in recent years, particularly after the 2008 Financial Crisis, increasing market share to 14% of combined industry AUM at the end of 2011, up from 10% in 2007 according to a survey released today by Citi (C) Prime Finance at the Managed Funds Association’s Annual Conference, Forum 2012 in Chicago. The report, “Moving into the Mainstream: Liquid CTA/Macro Strategies and Their Role in Providing Portfolio Diversification,” outlines key factors that make liquid CTA/Macro managers attractive to investors relative to long-only and hedge fund strategies and provide a ready source of liquidity in times of market stress.

From their original position atop the retail and high net worth investor’s “risk pyramid,” the Liquid CTA/Macro industry has broadened out and become a core portfolio component for institutional investors in recent years – from public and corporate pensions to endowments and foundations to family offices.

The research indicates that positive, uncorrelated performance during the 2008 Global Financial Crisis helped accelerate this expansion in the industry’s investor base. Yet, the industry itself also changed to accommodate this new institutional target market. To absorb the extensive asset flows originating from institutions, the industry sought means to extend its capacity and reduce portfolio volatility.

“A significant shift in investment approach has taken place since the 2008 Global Financial Crisis and investors, particularly institutional investors, have been actively looking to diversify their portfolios to better weather periods of unusual market stress,” said Jerome Kemp, Global Head of Futures and OTC Clearing.

As the investor audience base has grown, the distribution model too has evolved. Whereas money was primarily raised for these managers by wire house financial advisors via managed futures product in the early years of the industry, managers now list their funds on institutionally focused capital raising platforms and further develop their own hedge fund-like marketing teams to directly raise assets.

The survey also finds that there has been a decisive shift within the Liquid CTA/Macro manager landscape toward systematic as opposed to discretionary trading. Whereas AUM was fairly evenly split between these two approaches in 2000 (55% systematic and 45% discretionary), according to Barclay Hedge that ratio changed dramatically to 83% systematic and 17% discretionary by the end of 2011.

“These trends are not only driving the industry to be more systematic, but they are also changing the nature of the systems being deployed by participants and allowing for increasingly dynamic and innovative trading models,” continued Sandy Kaul, US Head of Business Advisory for Citi Prime Finance.

According to the research, there has been a significant expansion in the number of models being used to evaluate opportunities, a dramatic shortening of the time frame under consideration, and broad growth in the number of markets being tracked resulting in distinct “generations” of systematic approaches:
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Generation One – primarily a long-term trend-following system focused on the traditional commodity markets •
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Generation Two – a set of models with broader measures such as mean reversion, momentum, volatility, and others focused on a more expansive set of financial and currency contracts •
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Generation Three – further set of expanded models that layer multiple sets of models on top of the same market and allow prices and positions to be translated across markets and into alternative measures •

This paper is the result of a series of qualitative interviews conducted with an audience of CTAs and hedge fund managers focused on highly liquid macro strategies, as well as investors and other participants involved with allocating to these strategies. In total, the participants represented AUM of $86.5 billion USD, just over 25% of the industry’s total allocations.

The full report can be viewed at:

http://icg.citi.com/icg/global_markets/prime_finance/business_advisory.jsp

EMERGING MARKETS HEDGE FUND CAPITAL SURGES TO NEW RECORD

Funds investing in Russia, India and Latin America lead 1Q gains;

New allocations concentrated in Emerging Asia, Russia

Emerging Markets hedge funds posted their strongest start to a calendar year since 2006 with the HFRI Emerging Markets (Total) Index posting an industry-leading gain of +7.3 percent in 1Q12, according to the latest HFR Emerging Markets Industry Report, released by HFR (Hedge Fund Research, Inc), the leading provider of data, indices and analysis of the global hedge fund industry. Total capital invested in Emerging Markets hedge funds soared to a record of $127.3 billion (802 billion RMB) to end 1Q12, an increase of nearly $10 billion since year-end 2011, eclipsing the previous AUM record of $123 billion set in 2Q11. This increase in capital was driven by performance-based gains, as net new capital flows from investors remained muted, with funds experiencing inflows totaling $3.1 billion, while those experiencing outflows totaled $3.4 billion, resulting in a modest net outflow of $365 million in 1Q12. New capital flows were concentrated in Emerging Asia and Russia/Eastern Europe, which received $500 million in net new capital combined.

In addition to the strong performance across global emerging markets, hedge funds focused on specific EM regions posted even stronger gains in 1Q. The HFRI EM: Asia ex-Japan Index gained +7.3 percent, its best first quarter return since 2006, outperforming the Shanghai Composite by nearly 300 bps. The HFRX Latin America Index gained +8.4 percent, its best 1Q performance since 1999, mirroring strong gains across Latin American equities. The volatile HFRX Russia Index gained +11.0 percent, mirroring a similar gain from 2010 and the strong Hed ge Fund Research performance of Russian equities. The biggest gains in EM hedge funds were from funds investing in India, with the HFRX India Index gaining +18.8 percent during the quarter, outperforming Indian equity markets by 600 bps.

Number of Emerging Markets hedge funds eclipses record

The number of EM hedge funds continued to increase in the first quarter and now stands at 1,059 funds globally, eclipsing the previous record of 1,046 from 2007. Nearly half of all EM funds invest primarily in Emerging Asia, while the number of funds dedicated to investing in the MENA region increased by 20 percent in 1Q12. Over 15 percent invest primarily in Russia & Eastern Europe while nearly 10 percent of EM funds invest primarily in Latin America.

“Hedge funds investing in Emerging Markets continue to exhibit a resiliency to many of the developed market centric risk factors which continue to dominate investor concerns, posting record gains as developed market economies struggle with outstanding debt, low fixed income yields and weak growth prospects,” stated Kenneth J. Heinz, President of HFR. “In a similar manner to the broader global economy, EM hedge funds will play a crucial role serving as the growth engine in the expansion of the hedge fund industry by offering sophisticated, transparent investment strategies in emerging economies to a growing audience of global investors.”

Centre for Hedge Fund Research Reports

Research in the Centre for Hedge Fund Research is continuing, with projects underway on the analysis of predictability in hedge fund returns; correlation risk exposure and hedge fund performance; intraday patterns in FX rates; dynamic portfolio construction; and the pricing of basket options.

Working Papers

Paper 08
Investing in Hedge Funds when the Fund's Characteristics are Exploitable
Juha Joenväärä (University of Oulu), Hannu Kahra (University of Oulu)

In this paper we form hedge fund investment strategies that exploit optimally fund characteristics using the Brandt, Santa-Clara, and Valkanov (2009) approach. We exploit economically well motived fund characteristics based on managerial incentives, share restrictions, and the fund size. The optimal portfolio weight of a specific hedge fund can be seen as a ranking between funds. The results suggest that small funds with high managerial incentives and long notice periods obtain the highest rankings. Our findings suggest that the proposed characteristics-based strategy delivers significant outperformance for a real-time investor. The results are robust across a wide range of performance measures even after controlling for underlying redemption and subscription impediments associated with investment decisions.

Paper 07
Locked Up by a Lockup: Valuing Liquidity as a Real Option
Andrew Ang, Nicolas P.B. Bollen

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of 3. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.

Paper 06
The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage
Xuewen Liu (Imperial College Business School), Antonio S. Mello (Imperial College Business School)

During a  financial crisis, when markets most need liquidity and arbitrage trading to correct prices, hedge funds reduce their exposures and positions. The paper explains this phenomenon in light of coordination risk. We argue that the fragile nature of the capital structure of hedge funds, combined with low market liquidity, introduces coordination risk to hedge fund's investors. Coordination risk effectively limits hedge funds' arbitrage capabilities. We present a model of hedge funds' optimal asset allocation with coordination risk. We show that hedge fund managers behave conservatively and even give up participating in the market when they factor coordination risk into their investment decisions. The model gives a new explanation to the limits to arbitrage. We also discuss other implications of the model.

Paper 05
Equilibrium Index and Single-Stock Volatility Risk Premia
Andrea Buraschi (Imperial College London), Fabio Trojani (University of Lugano), Andrea Vedolin (University of Lugano)

Writers of index options earn high returns due to a significant and high volatility risk premium, but writers of options in single-stock markets earn lower returns. Using an incomplete information economy, we develop a structural model with multiple assets where agents have heterogeneous beliefs about the growth of firms' fundamentals and a business-cycle indicator and explain the different volatility risk premia of index and single-stock options. The wedge between the index and individual volatility risk premium is mainly driven by a correlation risk premium which emerges endogenously due to the following model features: In a full information economy with independent fundamentals, returns correlate solely due to the correlation of the individual stock with the aggregate endowment ("diversification effect"). In our economy, stock return correlation is endogenously driven by idiosyncratic and systemic (business-cycle) disagreement ("risk-sharing effect"). We show that this effect dominates the diversification effect, moreover it is independent of the number of firms and a firm's share in the aggregate market. In equilibrium, the skewness of the individual stocks and the index differ due to a correlation risk premium. Depending on the share of the firm in the aggregate market, and the size of the disagreement about the business cycle, the skewness of the index can be larger (in absolute values) or smaller than the one of individual stocks. As a consequence, the volatility risk premium of the index is larger or smaller than the individual. In equilibrium, this different exposure to disagreement risk is compensated in the cross-section of options and model-implied trading strategies exploiting differences in disagreement earn substantial excess returns. We test the model predictions in a set of panel regressions, by merging three datasets of f irm-specific information on analysts' earning forecasts, options data on S&P 100 index options,options on all constituents, and stock returns. Sorting stocks based on differences in beliefs, we find that volatility trading strategies exploiting different exposures to disagreement risk in the cross-section of options earn high Sharpe ratios. The results are robust to different standard control variables and transaction costs and are not subsumed by other theories explaining the volatility risk premia.

Paper 04
Differences in Beliefs and Currency Risk Premia
Alessandro Beber (Amsterdam Business School), Francis Breedon (Imperial College London), Andrea Buraschi (Imperial College London)

This paper investigates how heterogeneous beliefs of professional investors impact on the currency
options market. Using a un ique data set with detailed information on the foreign-exchange forecasts
of about 50 market participants over more than ten years, we construct an empirical proxy for dif-
ferences in beliefs. We show that our proxy has a statistically and economically strong effect on the
implied volatility of currency options beyond the volatility of current macroeconomic fundamentals.
We document that di¤erences in beliefs impact also on the shape of the implied volatility smile,
on the volatility risk-premia, and on future currency returns. Our evidence demonstrates that a
process related to the uncertainty about fundamentals has important asset pricing implications,
even in the absence of short-selling constraints.

Paper 03
Model Averaging in Risk Management with an Application to Futures Markets
M. Ha shem Pesaran (University of Cambridge, CIMF, GSA Capital and USC), Christoph Schleicher (GSA Capital), Paolo Zaffaroni (Imperial College London and CIMF)

This paper considers the problem of model uncertainty in the case of multi-asset volatility models and discusses the use of model averaging techniques as a way of dealing with the risk of inadvertently using false models in portfolio management. Evaluation of volatility models is then considered and a simple Value-at-Risk (VaR) diagnostic test is proposed for individual as well as `average' models. The asymptotic as well as the exact finite-sample distribution of the test statistic, dealing with the possibility of parameter uncertainty, are established. The model averaging idea and the VaR diagnostic tests are illustrated by an application to portfolios of daily returns on six currencies, four equity indices, four ten year government bonds and four commodities over the period 1991-2007. The empirical evidence supports the use of `thick' model averaging strategies over single models or Bayesian type model averaging procedures.

Paper 02
Dynamic Portfolio Optimisation when Investors Have CRRA Preferences
James Sefton (Imperial College Business School)

Given investors risk-return preferences can be represented using a standard utility function (CRRA), the problem of maximizing the total return to a portfolio with regular rebalancing over a given horizon can be rewritten as an optimal risk-sensitive (or H8) control problem.

F urther if the dynamic evolution of the forecasts to th e equity assets can be written as linear stochastic system – which can encompass a simple representation of trading transaction costs as in Engle, Ferstenberg (2007) and Almgren, Chriss (2000) – then the dynamic optimal portfolio can be written in terms of the solution to a matrix Riccati equation.

This optimal dynamic portfolio can be rewritten as the optimal static mean-variance portfolio plus a weighted sum of Merton (1973) hedging portfolios. This solution procedure is applied to both the forecast horizon problem described above and to the finite-horizon dynamic asset allocation problem discussed in Campbell and Viceira (2003).

Paper 01
Hedge Funds, Managerial Skill, and Macroeconomic Variables
(previously circulated under the title "Investing in Hedge Funds When Returns are Predictable")
Doron Avramov (R.H. Smith School of Business, University of Maryland), Robert Kosowski (Imperial College Business School), Narayan Y. Naik (London Business School), Melvyn Teo (Singapore Management University)

This paper evaluates hedge fund performance through portfolio strategies that incorporate predictability based on macroeconomic variables. Incorporating predictability substantially improves out-of-sample performance for the entire universe of hedge funds as well as for various investment styles. While we also allow for predictability in fund risk loadings and benchmark returns, the major source of investment profitability is predictability in managerial skills. In particular, long-only strategies that incorporate predictability in managerial skills outperform their Fung and Hsieh (2004) benchmarks by over 17 percent per year. The economic value of predictability obtains for different rebalancing horizons and alternative benchmark models. It is also robust to adjustments for backfill bias, incubation bias, illiquidity, fund termination, and style composition.

Hedge Funds: The evolution of an industry

This paper, The evolution of an industry</i>, features analysis of a recent survey of 150 global hedge fund managers by KPMG and the Alternative Investment Management Association (AIMA) Ithighlights their insights and opinions on a range of issues that are changing the face of the industry, including a shifting investor base, an increased focus on operational infrastructure and the implications associated with a continuing wave of global regulation.
>The evolution of an industry articles:

The institutionalization of the global hedge fund industry
The continued bifurcation of the industry
Geographical implications and trends
The trend toward greater transparency
The increased focus on due diligence
How the industry is adapting to the changing regulatory landscape

Key Findings:

- Nearly 60% of all hedge fund assets are from institutional investors.

- 90% of respondents report an increase in due diligence.

- 84% indicate that they had increased transparency since 2008.

- Investor size is correlated to manager size as large institutional investors typically allocate to large hedge fund managers, while individual investors are more likely to invest in smaller firms. And conversely, allocations are twice as likely to go into funds of hedge funds with less than $500 million in assets as opposed to larger firms with more than $1 billion in assets.

CHINA EMERGES AS ASIAN HEDGE FUND CAPITAL

Hedge funds investing in Emerging Asia posted industry-leading gains to start 2012, with the HFRI EM: Asia ex-Japan Index gaining +7.4 percent in 1Q12, the best start for the index since 2006 when it gained +12.3 percent, according to data released today by HFR, the leading provider of data, indices and analysis of the global hedge fund industry. The HFR index of Emerging Asia hedge funds easily outperformed Chinese equity markets by over 450 basis points for 1Q; recent gains follow a volatile 2011 which saw the HFRI Asia Index decline by -18.08 percent. In contrast, while the HFRX Japan Index gained +5.2 percent for 1Q12, it trailed the strong quarterly gain of +19.2 percent for the Nikkei 225.

The number of active Asia-focused hedge funds increased to 1,101, approaching the record number of 1,107 Asia-focused hedge funds set in 4Q07. Total capital invested in the Asian hedge fund industry increased by over $4.5 billion since YE 2011 to $86.6 billion (544 billion reminbi; 6.9 trillion Japanese Yen) to end 1Q12. Asia-focused funds experienced a modest net capital of investor outflow for the quarter of $256 million (0.29 percent of capital); the sum of all funds which experienced net inflows totaled $1.39 billion, while funds experiencing net redemptions totaled $1.64 billion.

China has continued to emerge as the preferred location for hedge fund firms investing in Asia, with 30 percent headquartered in China, a significant increase since 1Q09 when 20% were China-based. Globally, China trails only the US, UK and Switzerland as the preferred location for hedge funds worldwide, ahead of both Canada and France by number of hedge funds. In the Asian region, Singapore is the second-most preferred location for Asian-focused funds, with nearly 10 percent of funds located there, followed by Australia and Japan, respectively.

“It is difficult to overstate how important the ability for investors to access Asian markets and investors as an integral component of the growth of the global hedge fund industry in coming years,” stated Kenneth J. Heinz, President of HFR. “China will continue to emerge as the capital of the Asian hedge fund industry, representing integral access to specialized local expertise and insight of Asian markets as sophisticated hedge fund strategies evolve to operate in these markets. As this occurs, funds operating in Hong Kong, Shanghai and Singapore will be as relevant and significant to investors as those operating in New York, London and Zurich.”