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How to Incorporate Hedge Funds into a Portfolio Virginia Reynolds Parker, CFA Founder & Chief investment Officer P ARKER G LOBAL S.

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Presentation on theme: "How to Incorporate Hedge Funds into a Portfolio Virginia Reynolds Parker, CFA Founder & Chief investment Officer P ARKER G LOBAL S."— Presentation transcript:

1 How to Incorporate Hedge Funds into a Portfolio Virginia Reynolds Parker, CFA Founder & Chief investment Officer vir@parkerglobal.com P ARKER G LOBAL S TRATEGIES, LLC

2 “You've got to go out on a limb sometimes because that's where the fruit is.” Will Rogers

3 Primary Impediments Primary Impediments to Hedge Fund Investing  Headline Risk34%  Returns will come down (and correlation up)31% As more money enters the market As more money enters the market  Lack of Investment Process Transparency14%  Can’t get comfortable with the fees12% (both HFs and FoHFs) (both HFs and FoHFs)  Too Large to put enough capital to work 9% Source: Casey, Quirk & Acito and The Bank of New York (2004)

4 INVESTING CONSERVATIVELY

5 “Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.” Will Rogers

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7 Keys to Investing Conservatively  Expertise & Experience Hire expertise Consultant or FoHFHire expertise Consultant or FoHF  Diversification Limit manager & strategy riskLimit manager & strategy risk  Disciplined Monitoring Develop a frameworkDevelop a framework  Embrace Evolution Be among the FittestBe among the Fittest

8 “Experience is the name every one gives to their mistakes.” Oscar Wilde

9 The Learning Curve 1994 Surprise Fed Tightening Mortgage, Bonds, EM Collapse Demise of the 3 Davids 2000 Tech Bubble Bursts 3 year bear market 2007 Sub-Prime & Credit Crisis Time Knowledge 1990199119981997 1996 19951994199319921999200120032004200520062007 2008 20022000 1989-1990 S&L Crisis Collapse of HY Market 1998 Russian Default, LTCM Spreads widen

10 Risk-Adjusted Performance Comparison Alternative Investment Strategy Universe 10 Year Risk-Adjusted Returns Hedge Funds S&P 500 Compounded Annual Return % Scaled to 5% Annualized Volatility

11 Correlations to HFR Hedge Fund Index January 1998 – 2007Q3

12 Investment Strategy Universe Performance in the Tough Years

13 Investment Strategy Universe Performance in the Tough Years

14 Investment Strategy Selection Rigorous Research on the Following Considerations: Universe analysis of investment strategies  Universe analysis of investment strategies  Predictability and robustness of return expectation  Liquidity of positions  Diversification among strategies  Risk-adjusted returns  Sharpe Ratios and Implied VARs  Operational complexity  Current market opportunity  Exposure to extreme risk

15 Funds of Hedge Funds “Price is what you pay. Value is what you get.” Warren Buffett

16 Manager Selection Quantitative - where consideration should begin Performance Analysis  Performance Analysis relative to market opportunity and operational demands  Risk Analysis variance of returns  amplitude of drawdowns & recovery  liquidity  operational  market Qualitative - where the decision should be made Rigorous due diligence Operational controls and timely reporting Depth of staff Sufficient transparency of positions and process Industry reputation Experience of key professionals

17 Final Allocation  Practical application of modern portfolio theory Limit manager/strategy concentration Optimize portfolio allocation given constraints including maximum and minimum allocations Apply traditional models with static inputs; consider models with dynamic parameters  Scenario analysis & stress tests xpected returns Expected returns Expected risks Expected risks Expected shortfall across strategies Expected shortfall across strategies  Consider current market conditions

18 MANAGING HEDGE FUND RISKS

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20 “Risk comes from not knowing what you're doing.” Warren Buffett

21 Risks Involved in Alternative Investment Strategies Same as traditional strategies: Market  Market  Structural Market Change  Credit  Liquidity  Legal  Operational  Human  Performance Shortfall

22 Successful Risk Management Policies and Procedures  Policies and Procedures  Middle Office – The Independent Inspector  Quantitative Models  Strict Accounting Standards  Savvy Managers

23 Downside Deviation  Downside Deviation Minimal Acceptable Return  Maximum Acceptable Loss Minimal Acceptable Return  Maximum Acceptable Loss Scenario Analysis  Scenario Analysis Monte Carlo  Recursive Models The Quantitative Tools Value at Risk  Value at Risk Contribution to Risk Incremental Risk Stress Testing  Stress Testing Key Drivers  Factor Analysis 

24 BarraOne Local Market Risk

25 BarraOne Global Factor Risk

26 BarraOne Total Risk

27 “Success is a lousy teacher. It seduces smart people into thinking they can't lose.” Bill Gates

28 Amaranth  Multi-strategy fund launched $600 million in 2000 with significant convertible arbitrage component  14.72% Compounded return net through November 2005  Perfect storm in convertible arbitrage begins in May 2003 – lackluster returns are large redemptions over the next few years  Trying to maintain returns where most components of arbitrage related multi-strategy funds had fewer opportunities  2002 added energy trading, August 2006 had 51% of the open interest

29 Amaranth Growth of $1000 Source: CISDM

30 Amaranth Monthly Returns Source: CISDM

31 Amaranth  Style Drift  Reckless Risk Management  Bad Investment  Cornered Market trapped in a roach motel

32 US SUBPRIME MORTGAGE MARKET: TICKING TIME BOMB 25% of the US mortgage market was subprime in 2006, accounting for $722 billion of loans originated Borrowers were accustomed to refinancing when ARMs reset – now interest rates are increasing home equity is decreasing Foreclosures are up 60-70% over 2006 (end of the process) Foreclosure notices are up 127% over 2006 (start of the process) Bond investors stand to lose up to $75 billion in securities backed by subprime according to PIMCO $100 billion of subprime debt went in $375 billion in CDOs in 2006

33 ARM RESETS

34  FICO of approximately 630  50% are cash-out refinancings  Loan to Value > 80%  30% have 100% financing  30% are in California  42% have limited documents (merely stating income)  40% Debt-to-Income Ratio  84% of loans are ARMs (adjustable rate mortgages)  7.3% Teaser  Resets to Libor + 600 bps SUBPRIME MORTGAGE CHARACTERISTICS OF ABX INDEX

35 Performance of ABX A 06-2

36 Summary  Diversify across markets, strategies and managers  Invest in people, not in numbers  Clearly understand strategies you select, where the majority of the universe is profitable on an annual basis  Place a premium on transparency, whether investing in a fund of funds or directly with hedge fund managers

37 Hedge Funds Can Perform Growth of $1000 January 1990 – 2007Q3 Bull Market Bear Market Bull Market HF Index S&P 500 Global Bonds MSCI

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39 P ARKER G LOBAL S TRATEGIES, LLC 1177 Summer Street Stamford, CT 06905 Phone (203) 358-4000 email: info@parkerglobal.com info@parkerglobal.com www.parkerglobal.com


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