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ACTUARIAL INSIGHTS INTO HEDGE FUND MANAGEMENT R S Clarkson.

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Presentation on theme: "ACTUARIAL INSIGHTS INTO HEDGE FUND MANAGEMENT R S Clarkson."— Presentation transcript:

1 ACTUARIAL INSIGHTS INTO HEDGE FUND MANAGEMENT R S Clarkson

2 Risk is downside in nature Risk is downside in nature Look beyond the recent past. Look beyond the recent past. Watch out for departures from prudent behaviour. Watch out for departures from prudent behaviour. There is nothing to fear but fear. There is nothing to fear but fear. Equities, not bonds or cash, for the long run. Equities, not bonds or cash, for the long run. Beware of rising inflation. Beware of rising inflation. The power of developing nations. The power of developing nations. Investment of the fourth kind. Investment of the fourth kind.

3 RISK IS DOWNSIDE IN NATURE ADAM SMITH ADAM SMITH The chance of loss is by most men undervalued. BENJAMIN GRAHAM BENJAMIN GRAHAM Security of capital. WARREN BUFFETT WARREN BUFFETT Harm or injury to purchasing power. FINANCE THEORY FINANCE THEORY Variance or standard deviation of past return OCTOBER 1992 OCTOBER 1992 Equities about to become much less risky?

4 LOOK BEYOND THE RECENT PAST OFF THE RADAR SCREEN OFF THE RADAR SCREEN Our data didnt go back far enough BLACK SWAN BLACK SWAN It was an event that had never happened before. FIVE SIGMA EVENT FIVE SIGMA EVENT No significant probability on our model

5 LOOK BEYOND THE RECENT PAST LONG-TERM CAPITAL MANAGEMENT 1998 LONG-TERM CAPITAL MANAGEMENT 1998 Models did not go back to 1992 or 1987 NORTHERN ROCK FSA COMMENT 2007 NORTHERN ROCK FSA COMMENT 2007 We had it as a low probability of getting into difficulty ALLIANCE & LEICESTER COMMENT 2007 ALLIANCE & LEICESTER COMMENT 2007 Our strategic review in 1999 underestimated correlations ROYAL BANK OF SCOTLAND CHAIRMAN 2008 ROYAL BANK OF SCOTLAND CHAIRMAN in 10,000 chances do turn up UBS COMMENT 2008 UBS COMMENT 2008 Crucial risk model based on favourable 5 year period with low volatility

6 WHICH BANK? WHICH YEAR? Few directors had any real banking experience. Few directors had any real banking experience. Committed the cardinal banking sin of lending long-term against short-term borrowing in the commercial money market. Committed the cardinal banking sin of lending long-term against short-term borrowing in the commercial money market. Deputation to Bank of England to ask for loan. Deputation to Bank of England to ask for loan. CONTEMPORARY COMMENT CONTEMPORARY COMMENT Universal loss of credit, endless suspicions Need to check previous exorbitant level of available credit Need to check previous exorbitant level of available credit

7 LOOK BEYOND THE RECENT PAST WINSTON CHURCHILL WINSTON CHURCHILL The further you look back in history, the further you can look forward. ADAM SMITH ADAM SMITH Restrictions on liberty of bankers necessary. INSTITUTE OF ACTUARIES INSTITUTE OF ACTUARIES Certum ex incertis – certainty out of uncertainties FACULTY OF ACTUARIES FACULTY OF ACTUARIES Ad finem fidelis – Faithful to the end

8 DEPARTURES FROM PRUDENT BEHAVIOUR Large private equity deals on low interest rates Large private equity deals on low interest rates Covenant-lite corporate borrowing Covenant-lite corporate borrowing Wall Street driving demand for sub-prime loans Wall Street driving demand for sub-prime loans No reasonable margin on sub-prime loans No reasonable margin on sub-prime loans Mortgages of 5 times joint salaries Mortgages of 5 times joint salaries 125% loan-to-value ratios 125% loan-to-value ratios £7.5m maximum mortgage – now £550,000 £7.5m maximum mortgage – now £550,000

9 THERE IS NOTHING TO FEAR BUT FEAR ADAM SMITH – HISTORY OF ASTRONOMY ADAM SMITH – HISTORY OF ASTRONOMY Panic terrors always excited by the sudden onset of unexpected danger. ALAN GREENSPAN – THE AGE OF TURBULENCE ALAN GREENSPAN – THE AGE OF TURBULENCE Normal rational behaviour impossible when fear exists. Even investment bankers can be paralysed by fear. US BANK TREASURER – SEPTEMBER 2007 US BANK TREASURER – SEPTEMBER 2007 People are terrified of reputational damage. They know it could be a career-ending move. US BANKER – SEPTEMBER 2007 US BANKER – SEPTEMBER 2007 Lending to anything east of a 212 local telephone code could be a terminal experience.

10 EQUITIES, NOT BONDS OR CASH, FOR THE LONG RUN RISK ELEMENT RISK ELEMENT Proportionate shortfall in real terms over given period OR Square of proportionate shortfall RISK VALUE RISK VALUE Average risk element over 100 year history UK EQUITIES AND LONG GILTS UK EQUITIES AND LONG GILTS Equities less risky over 4 years or longer EQUITY RISK PREMIUM PUZZLE? EQUITY RISK PREMIUM PUZZLE? Myopic loss aversion, corrected by actuarial approach

11 INVESTMENT OF THE THIRD KIND NEW MONEY SEPTEMBER 2000 Billiton also rights issue Billiton also rights issue Rio Tinto Rio Tinto Lloyds TSB Lloyds TSB Standard Chartered Standard Chartered ICI also rights issue ICI also rights issue Rentokil Initial Rentokil Initial FTSE All-Share Index 40% fall to December 2002 September 2000 new money 4% fall to December 2002

12 BEWARE OF RISING INFLATION 12TH MARCH TH MAY 2008 FINANCIAL TIMES INSIGHT ARTICLE INSIGHT ARTICLE Inflation cat jumps out of the bag to stalk credit markets. There is little useful history to predict what might happen to the corporate bond market if inflation really does take hold. MARKETS MARKETS Bond yields hit high as inflation fears mount.

13 THE POWER OF DEVELOPING NATIONS Very rapid economic growth Very rapid economic growth Less restrictive legislation Less restrictive legislation BUT danger of high inflation BUT danger of high inflation BUT poorer corporate governance BUT poorer corporate governance Sovereign wealth funds Sovereign wealth funds Strategic stakes in key industries Strategic stakes in key industries

14 INVESTMENT OF THE THIRD KIND RISK SCREEN RISK SCREEN Inadmissible if significant fall in earnings MEDIUM TERM VALUE SCREEN MEDIUM TERM VALUE SCREEN Rank by utility function U = G – cR G 12 months consensus earnings growth G 12 months consensus earnings growth R prospective price-earnings ratio R prospective price-earnings ratio C positive constant to disadvantage high R C positive constant to disadvantage high R PORTFOLIO GUIDELINES PORTFOLIO GUIDELINES 4% in top % in next % in next 10 Annual rebalancing PERFORMANCE TREND PERFORMANCE TREND Around 5% p.a. out performance of FTSE All-Share Index

15 DECEMBER 2005 ASSESSMENTS FTSE 100 COMPANIES Rank Company February 2006May BHP Billiton ! Man Group ! Persimmon ? Northern Rock ?? 114 ? FTSE All-Share Index

16 DECEMBER 2005 ASSESSMENTS FTSE 250 COMPANIES Rank Company February 2006 May Venture Production ! Vedanta Resources ! *Burren Energy ! Lonmin ! Tullow Oil ! Informa William Hill Kensington Group ?? 108 ? 9Amlin Logica CMG FTSE All-Share Index FTSE All-Share Index * Reinvested in ENRC December 2007

17 INVESTMENT OF THE FOURTH KIND RISK SCREEN RISK SCREEN Inadmissible if significant fall in earnings MEDIUM TERM VALUE SCREEN MEDIUM TERM VALUE SCREEN Require high value of U = G – cR LONG TERM VALUE SCREEN LONG TERM VALUE SCREEN Rank by 4-component long-term growth rate (LTGR) PORTFOLIO GUIDELINES PORTFOLIO GUIDELINES Highly unconventional – similar to Warren Buffett PERFORMANCE TREND PERFORMANCE TREND Around 10% p.a. out performance of FTSE All-Share Index ?

18 PORTFOLIO GUIDELINES Maximum investment 5% of current portfolio value Maximum investment 5% of current portfolio value Ignore sector weightings Do not sell unless overvalued in terms of U or LTGR deteriorates. Do not sell unless overvalued in terms of U or LTGR deteriorates. Do not rebalance. Do not rebalance. Switch if much more attractive opportunity available Switch if much more attractive opportunity available Eg: XSTRATA Eg: XSTRATA Cost 2.5% of May 2008 portfolio value Valuation 18% of May 2008 portfolio value

19 LONG TERM GROWTH RATE Volume growth Volume growth Size and stability of profit margins Size and stability of profit margins Ability to finance growth Ability to finance growth Operational flexibility in economic downturn Operational flexibility in economic downturn Assess each component on scale of 1 to 7 Assess each component on scale of 1 to 7

20 MAN GROUP VOLUME GROWTH Fast becoming the McDonalds of alternative assets Fast becoming the McDonalds of alternative assets Excellent performance of AHL Diversified fund Excellent performance of AHL Diversified fund BUT poor Global Strategies performance BUT poor Global Strategies performance Targeting individuals and institutions enriched by commodities boom Targeting individuals and institutions enriched by commodities boom Good global retail network Good global retail network Still expanding unlike many competitors Still expanding unlike many competitors

21 MAN GROUP SIZE AND STABILITY OF PROFIT MARGINS AHL costs investors 4% p.a.and 20% performance fee AHL costs investors 4% p.a.and 20% performance fee Elsewhere around 2% p.a. and 20% Elsewhere around 2% p.a. and 20% No serious threat to high industry margins No serious threat to high industry margins ABILITY TO FINANCE GROWTH ABILITY TO FINANCE GROWTH Low expansion costs because of franchise nature Low expansion costs because of franchise nature $1.5bn cash to buy smaller rivals and hire talent $1.5bn cash to buy smaller rivals and hire talent OPERATIONAL FLEXIBILITY IN ECONOMIC DOWNTURN OPERATIONAL FLEXIBILITY IN ECONOMIC DOWNTURN AHL thrived in recent turbulence AHL thrived in recent turbulence Demand for alternative assets increases in difficult times Demand for alternative assets increases in difficult times More opportunities from tighter bank regulation More opportunities from tighter bank regulation

22 2007 HEDGE FUND PERFORMANCE CS TREMONT DATA SECTOR% SECTOR% ALL HEDGE FUNDS12 Multi-Strategy12 Equity Market Neutral 9 Risk Arbitrage 9 Distressed 8 Dedicated Short Bias 6 Managed Futures 6 Convertible Arbitrage 5 Fixed Income Arbitrage 4 FTSE All-Share Index 2

23 2007 HEDGE FUND PERFORMANCE CS TREMONT DATA SECTOR% SECTOR% Emerging Markets 20 Emerging Markets 20 Global Macro 17 Global Macro 17 Event Driver Multi-strategy 17 Event Driver Multi-strategy 17 Long/Short Equity 14 Long/Short Equity 14 Event Driven 13 Event Driven 13 ALL HEDGE FUNDS 12 ALL HEDGE FUNDS 12 FTSE All-Share Index 2


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