Our Views - Hedge Fund Books

Polls

The main reason of the current meltdown

	Incompetence
	Greed
	Inevitable cyclicity
	Globalization

What People Say

A must read Funds of Funds is to my knowledge, the first hedge fund related book in the market describing the complete process of FoF portfolio construction in depth. It is written by one of the industry experts, who introduces the details of hedge fund investing from the practitioner’s perspective. The book provides an excellent balance between the complex analytic and intuitive thought process.

It is a must read for every investors wishing to make an unbiased decision and for every fund manager interested in becoming a constituent fund.

Neal Berger
Apogee Capital Partners L.P.

Simply the best I have been waiting for this book for over six months. Excellent work, simply the best "funds of funds" book available. It gives you everything you need to build a top-performing hedge fund of funds: risk management, portfolio optimization, stress testing and so on. It is written in easy language and does not require a deep knowledge of the underlying maths.

What surprises me is that Dr Grauberg has compressed so much information that would be enough to write not one but several books.

Simon Elimelakh
BT Financial Group

Our Views

We will neither try to convince you to invest into hedge funds nor make brave statements about wonderful alternative investment industry. It is not our aim. Our mission is to provide professional investors with the sophisticated tools, methodologies and unbiased opinions how to invest into the most contradicting yet ambiguous investment sector safely.

It is common knowledge that the most gifted managers are drawn first to the hedge fund industry. However, their top performance fees and lavish lifestyle equally attract a lot of people that can be hardly called competent professionals. On the other hand, we are witnessing a massive crowd of institutional investors constructing portfolios of hedge funds without any clue how to incorporate appropriate due diligence and risk management frameworks.

Our expertise is based upon real hands-on investments in hedge funds, equity - derivatives trading experience and, most importantly, own money investing. Therefore, our views of alternative investments often differ from the common standpoints. In brief, our viewpoints could be summarized as follows.

Hedge Fund Risk Assessment

Using the mean-variance framework for hedge fund risk assessment is the most common yet devastating mistake. Since hedge funds exhibit a high degree of non-normality of their distributions of returns, the risk measures based on the normality assumption (ex. the standard deviation and its derivatives like the Sharp or Sortino ratios) cannot be used.

Unfortunately, despite numerous studies on this matter clearly evidencing inapplicability of the mean-variance methodology for hedge funds, it is still the dominating approach used by the majority of institutions and advisories. Why? Is it a sign of wild incompetence, inability to learn or just ignorance of the facts?

The mean-variance methodology and its derivatives should not be applied for hedge fund risk assessment as such.

Due Diligence I (Quantitative)

Although institutions have been conducting due diligence for years, their routine procedures mainly focus on its qualitative side. Thus, the main drawback of the commonly used due diligence frameworks is a lack of its quantitative component. Conducted blindly and formally based on filling pre-designed questionnaires, such due diligence process is largely worthless, because does not provide a deep analysis of fund performance and risk management.The commonly calculated performance indicators are all based on the mean-variance methodology, which is inapplicable to hedge funds exibiting a high degree of non-normality.

A sophisticated due diligence process should include a full-scale quantitative analysis
The quantitative part should address numerous peculiarities of hedge funds: non-normal distributions of returns, index biases, low correlation with their indices, and limited return series

Due Diligence I (Qualitative)

Most commonly used qualitative due diligence frameworks, though differ in details, share a few drawbacks:

based on formal pre-designed questionnaires and do not deliver deep insights to trading strategies and risk management procedures
analysis of manager skills is substituted by a blind background check
personal contacts with managers are paramount and, as such, may override any potential irregularities

In contrast, our views on qualitative due diligence imply different aspects:

The core purpose of qualitative die diligence is to examine risk management and reading strategies rather than filling worthless forms. Personal contacts with managers should be minimized to ensure unbiased decisions.

Transparency

Low transparency of hedge funds is often viewed as a key risk factor of alternative investments, while the term transparency is referred to fund asset allocations. Such a standpoint ignores the fact that the degree of investment risk depends on the way of structuring assets in the portfolio, rather than on assets themselves. Fund managers may dynamically rebalance assets, use derivatives for hedging, apply complicated multi strategies and so on. As such, knowing the current asset allocation at any time, delivers most worthless information. The really important transparency aspects are as follows:

full transparency of fund risk management processes
full transparency of employed trading strategies and a fair understanding of how a fund makes money

Transparency of fund risk management and trading strategies matter a lot, while the worthiness of knowing asset allocation is highly overrated.

Fund Ratings

We strongly believe that hedge fund ratings provided by numerous rating agencies are worthless and, as such, should not be used as a sensible ground for an investment decision. First, fund ratings tend to be highly biased towards to institutional funds. Typically, being an institutional grade fund, implies getting a top-grade rating automatically.

Second, often ratings are done in a formal way by analysts having vague understanding of alternative investments. We have seen numerous examples when hedge funds, equities and currencies are rated by the same analysts.

Third, though denied as non-existing, a depraved practice of payment for good ratings does exist in the industry. Finally, everyone can find hundreds of examples, when collapsed funds had been maintaining great ratings all the way along. Remember the Lehman or Bear Stearns funds?

Allocations to hedge funds based on their ratings should be avoided by all means as highly misleading.

Finance Turmoil and Hedge Funds

During favorable markets, a key to hedge funds’ success is attributed to brilliant managers, but when the finance industry delves into troubles, huge hedge fund losses are typically explained by unfortunate market conditions. Both the statements are wrong. The nature of real hedge funds is to protect investments during any market conditions. If a fund loses 40-50% of its assets, it is not a real hedge fund, but a poor imitation.

We believe that the current economic meltdown presents a great health-improving opportunity for the industry. A sky-rocketing popularity of hedge funds and effortless making profits created a vast number of investment vehicles that can hardly be identified as employing any recognized hedging strategies. We have seen plenty of the so-called hedge funds fully investing into real estate (long only!) or funds with highly levered bond portfolios (long only as well). These vehicles have fully deserved to vanish into non-existence.

The current devastating performance of the alternative investments should be attributed to a huge number of investment vehicles classified as hedge funds, but, in reality, employing no real hedging strategies at all.

Investment Advisors

Though relatively uncommon for the global hedge fund industry, in a few countries (ex. Australia or New Zealand) investment advisory presents a massive middleman barrier between hedge funds and retail investors. The investment advisors’ layer makes direct transactions fund-investors hardly possible and imposes additional advisor fees on the top of fund management and incentive fees. While investment advisors cannot be held responsible for fund underperformance, this practice creates a number of devastating consequences:

biased investment advises based on higher fees rather than on fund performance
increasing amount of fees paid by end investors
inability of providing a valuable advice, because most advisories demonstrate limited knowledge of alternative investments

Allocations to hedge funds based solely on recommendations of investment advisors should be avoided by all means.

Tactical Asset Allocation

The TAA (Tactical Asset Allocation) framework implies constructing fund portfolios based on their labeled strategy and pattern behavior of the corresponding indices. While commonly used by most institutional managers for hedge FoF construction, it presents a highly misleading concept:

Fund managers may use multiple strategies, which makes it difficult to categorize
The whole TAA framework relies on the style-weighted allocation (read index-weighted allocation) that predetermines allocation across individual funds. Since the majority of hedge funds are not correlated with their corresponding indices, the applicability of the TAA becomes questionable.

The TAA framework should not be applied for constructing portfolios of hedge funds (hedge fund of funds) .

Madoff's Case: Why It Matters

madoff2 We are not going to delve into endless discussions of how Bernie Madoff has successfully managed to defraud hundreds of investors for years. We will not talk about the reasons of the SEC’s dereliction, when the latter was supposed to examine the Madoff’s books since 2006. All these aspects are largely irrelevant for us. What really matter is how highly respected financial institutions (ex. Credit Swiss) invested billions of dollars into the Madoff’s scheme without conducing any basic due diligence.

Oh, sorry, it is not correct. Of course, they had conducted full due diligence; everyone familiar with the institutional asset allocation system knows that it is impossible to make any new investments unless a huge paperwork burden is in place - including numerous investment committee approvals. A million dollar question: what is the typical institutional due diligence worth, if it cannot spot a simple Ponzi scheme?

Let’s stress it again: we are not talking about HNWI or any end investors that could be easily misled. We are talking about top-grade institutional investors with virtually unlimited resources and long established routines. Why did they fail? The answer, at our opinion, is obvious:

The common institutional due diligence practice is solely based on formal (and largely worthless) questionnaires that disregard a coherent trading strategy analysis. A fairly basic examination of employed strategies and/or risk management would spot the Ponzi scheme instantly.

By prioritizing the know-my-managers factor, the employed check-up practices (if any) mostly neglected any other elements of the Madoff’s investment process. His funds even never used an independent custodian, which itself was supposed to raise a red flag immediately. However, no one questioned this. How could one doubt anything? The only Madoff name itself was sufficient to build unlimited confidence.

The bottom line is simple: the Madoff’s case clearly illustrates inability of institutional investors of conducting any coherent due diligence, which, in turn, derives from inappropriate frameworks used. On the other hand, this case exposes a common practice of investing primarily based on personal industry contacts ("we know that guy"). While we cannot argue a great importance of such contacts, disregarding other factors always lead to Madoffs’ scams. Unless we see radical changes in the institutional due diligence and risk assessment practices, we will see more and more such cases, especially during uncertain times.

Home

About Us