My 14th year of doing "Introduction to hedge fund" invited lecture for E416 Hedge Funds elective at London Business School

1. Hedge Funds:
Data Evidence
Dr Drago Indjic
dindjic@london.edu
drago.indjic@richfox.com
London Business School E416
19 January 2018

2. Summary
• Demand: Alternative investment strategies
– Delegated investment management; Product
≡ Fund, or custom service
• Market size, growth, distribution, non-retail
products (B2B) vs growing D2C)
• Features: strategies and labelling, selection, usage
• Supply: private, non-corporate businesses
• Mostly micro (craftsman), owner/manager
• Dynamics
• macro, regulation; fee pressure; entrepreneurship

3. 2010s
• Hedge funds as an investment banking
career exit strategy
• Apr 2014: Volcker Rule s. 619 Dodd-Frank’s Act
proprietary trading ban
• An ex-banker can become an entrepreneur
• funding and managing the venture, raising assets
• Increasing regulation
• Higher business costs, clearing fees; less
institutional investment in start-ups; safer products

4. Popular Misconceptions
• Fraud, systemic risk, lockups, cost …BAD!
• Benefits: market efficiency (“Big Short”;
activists); downside protection opportunity

5. Pricing Investment Skill
• Extremes of price discovery: ETF ↔ funds

6. Big Picture
• Size of industry: $3.2t (HFR, 2017Q3)
• <ETF ($4.3t in ~3 firms), ECB, ~Top 3 SWFs
• ~7% or worldwide mutual funds ($42t)
• <Blackrock $5.7tn (nb. $1.7t, 2x YoY, 40% of all
ETFs @ ~20bps)
• $224b AQR (AUM +50% YoY) vs $285b SPDR
SPY ETF (9 bps (=), 1.7% yield, +70% YoY)
• More regulated and concentrated industry
• never too big to fail, +15% in 2008 by managed
futures (CTA) strategies

7. Growth
• AUM: doubled since 2009, stalled, yet …

8. Growth: Net Flows
• AUM: ± Performance ± Flows | QE

9. Growth: Self-Made
• The asset growth due to performance, not inflows;
making money, but earning less performance fees

10. Business Health
Fund Launches Closures
YTD 3Q17 545 618
FY 2016 729 1057

11. Concentration (1)
• >80% assets in large >$1b funds

12. Economics
• Demand for “cheap, liquid, Alpha”
– Prof. Fung: At what price? (or trust?)
• Intermediaries: 1/3 -> 1/7 of total market
– Fund of fund/Advisors: professional (offshore)
fund market imperfections; layered fees
• Supply: start up (not a job at a large firm)
– Hedge fund managers as innovators; never
too big to fail (LTCM ~20 yrs ago; Pelaton)

13. Demand
• Institutional investors
– Strategic asset allocation
• DGF %alternatives (PE, RE); % HFs; %”strategies”
• Pension funds: CALPERS exit, CalSTRS ups
• HNW (offshore) vs retail (onshore)
– “An investor domiciled in X buys units of fund
domiciled in jurisdiction Y”
– KYC, AML, GACTA, PEP …
– Modern, better fund structures: UCITS, AIF

14. Supply: Fund Manager
• Approved personnel in the regulated entity
• On-shore, taxed, more transparent: (UK:
authorised by FCA) LLP (private agreements);
staff, systems, service contracts
• Off-shore Ltd (authorised by e.g. Guernsey FSC,
cheaper) manages off-shore fund: corporate
“substance” and governance (NEDs)
• Start-up venture, not a listed company
• Manager(s) ↔ Founders-owners; micro-enterprise
• cash-flow (try credit scoring!), marketing sensitive

15. Micro-Enterprises
• Owner/Manager’s business
– Staff <10: even the largest are still SMEs
• Median “fund” AUM <$50m (@ 1.5% fee)
– Far less profitable business then in the past;
higher cost of seed capital
• Very few long-term survivors and “brands”
– Most new funds liquidated within 5-7 years
– not unlike many other start-ups or products

16. Data Quality
• Mostly private, lagged, fast aging
– Index: X% funds reporting MMM YY as at DD MM YYYY
• Reference data (transparent)
– Fund offering memorandum, counterparties
– Regulatory filings: AIFMD, SEC
• Business data
– Due diligence: staffing, references, accounts
– For example, managers own investment
• Portfolio data (on request)
– Monthly report, weekly NAVs → portfolio exposure and
(sometimes) holdings …. [→ real time: managed
accounts, e.g. HedgeMark]

17. Performance Data
• Low data quality: Voluntary disclosure
• HFR, Reuters Lipper, Morningstar: fund “boiler
plates” and self-reported performance estimates
(not prices/NAV) for many fund share classes
• Contact details “catalogues”
• No standard fund identifiers (ISIN)
• Short time series; the largest/smallest/“defunct”
funds excluded (self-selection, survivorship biases)
• Bloomberg etc blank; non-standard settlement;
fund administrators/brokers do not sell data

18. Fund Labeling
• What exactly is an investment strategy?
– Still by 1980s descriptive taxonomies: no
labelling standards; elicited by interviews and
case studies – e.g. not all funds are hedged,
not all “absolute” returns are positive
• Trust but verify
– Exposures vary across assets and time.
Transparency: necessary, not sufficient
criteria; data quality (no strategy ontologies)
– Danger: overpaying for Beta-like service

19. One Classification Scheme
• .

20. Performance by Strategy

21. Strategies Over Time
• Great traders have retired?

22. Indicative “Strategies”
• 10% are “multi-”
• 3% “other”
• …..
• and can change!

23. Not Available in ETF Universe
• Unique risk premia; volatility, events …

24. Indexing
• Peer groups, funds are not securities
– there is no “value”, ratios etc.
• Investability criteria
– 40% daily: liquid alternatives

25. Modern HF Exposure
• Direct
• Advised, non-discretionary: consultants (e.g.
Albourne), outsourced due diligence
• Platforms / Segregated Managed Account
• On-shore: alt UCITS products
• Large managers (e.g. Winton)
• Extinct and endangered
• FoHF: “fiduciary” - consultant’s stronghold
• Disappeared: Structured (capital protected)

26. Policy/Model Portfolio
• Total Risk/Benefit
– Not income but capital protection; “hedged”
core + “insurance”; risk-targeted, risk-profiled
– Alternative (even unique) risk premia sources
• Zero Beta; NAV in gold or oil
– Risks: mostly business, contractual (“key
man” w/o “exit”, equity financed), capacity
• Advantages
– Negotiate cost (of “Alpha”), liquidity, hurdles,
even business co-ownership (PE-like)

27. Follow The (Smart) Money
• Note defensive strategies: CTA, macro, “niche”

28. Portfolio Construction
• Top/Down or Bottom-Up
• “Strategy allocation” (%weight), e.g. CTA:
• Fund “selection” <> weighting(rebalance!)

29. Exposure Delivery Choice
• e.g. CTA: (select) fund (Winton, Palomar),
an index fund (light blue) or smart Beta?
• Capacity? Fees? Bargaining power?

30. Emerging Managers
• Opalesque, Dec 2017

31. Start-Ups: Higher Bar
• Minimum required AUM to consider a fund
• Wants “high %AUM be the partner’s capital”,
“stamp of approval from a respected seeder”
• Average investment size

32. Case Study: Investment Deals
• “I am offering this to suitable hedge fund managers as a one off
introduction only, at 15% of all fees for initial and any follow-on
investments for the first three years (if you want to charge more, fine
too). Happy to share those fees 50/50 if you know of any manager”
• “They provide significant upfront capital in return for stakes in the
GP of proven managers (generally a 50/50 JV). They are positioned
to allocate immediate capital investment of $100 million+ to a
manager that fits their criteria. Look at it as acceleration capital for
the top performing manager who can’t raise his assets to the level
required for institutional investors which these days is $300-500m.
The Seeder would also bring $1-4min working capital. There will
only be performance fees paid to the manager. After 2.5 years the
manager is free to take on outside capital at full fees”.

33. Incentive Contract Effects
• When making money is more difficult …
• … less earning large performance fees
feasible

34. Recommendations
• Focused, custom role in wholesale direct
and delegated DGF portfolios
– missing in small retail (D2C/IFA)
• “Liquid alternatives” – Alt UCITS
– Fast growing: +16% in 2017; EUR ½ tn
UCITS (of 9tn in 30,000 funds; 4% Alts)
• Seeding?

35. Conclusions
• Investment view
– Post-QE
– Passive >> active
– “stay rich”
• Financial innovation
– Investment contracting;
– Aligned incentives and governance

36. Demographics (1)
• Tyranny of TER:
– AUM <$100m for a long time (e.g. Cumulus)
– “Soft” performance/flows/age factors
– Jones (2016):

37. References
• Trade association: https://www.aima.org/
• Data: http://www.barclayhedge.com/; ESMA reports; @HFRInc
• News: http://www.opalesque.com/, esp. Roundtables;
www.finalternatives.com, http://www.ai-cio.com (not e.g. Asset TV or
InvestmentWeek)
• Seeding: Jones, M. (2016) http://www.aboutmjones.com/mjblog/;
Opalesque Emerging Managers Monitor

38. Concentration (2)
• Inflows becoming more equal wrt firm size

39. Demographics (2)
• “The top 50 HF firms have been in business for an average of
22 years. The average age of the founders of the top 50 funds
is 54” (2015)

40. Everybody Has “Best Funds”
• Caution with “awards” as per e.g. Hedge Fund Review
• ”Hedge funds reporting to the BarclayHedge database are
automatically entered in the performance categories. All other
managers are encouraged to download and complete an entry form
... (and) also invited to enter the qualitative categories, which reward
achievements in product development, innovation and client service”
“This year the awards also recognise best bespoke FoHF provider
and best advisory team from a fund of funds” .....
“The hedge fund investment process relies on more than just
numbers and the evaluation process recognises this” .....

41. Extras
• BlackRock is activist about 10% of the
time. Blackstone $92bn of “dry powder”
[Economist]

42. Complacency