Liquidity Risk and Alternative Beta Products

Dr Drago Indjic
London Business School June 2012

What is Risk Then?

Not just variance
Risk off/on

Correlation Beta Loss of capital Liquidity Access to capital (return of capital)

May 2012: Treasuries and Bunds

Downside Risk
Hedged, more agile strategies outperform: smaller losses, lower variance

Long-only, buy and hold strategies are riskier

Hedge Fund Exposure

Funds of hedge funds (Alpha)
Best Alpha is still most often packaged in form of private funds: illiquid, fees loaded

Index replicators (Beta)

Passive alternatives: alternative Beta, commoditised and liquid (ETF)

Separate Alpha and Beta components

mean vs tail; fair liquidity premium

Reminder: 2008 Performance

A hedge fund strategy on the top as in May 2012

Indirect Cost of Alpha

Monthly redemptions, 45 days notice Quarterly, 65 bd, 12 month Lockup Quarterly, 120d, 20% gate Quarterly, 60d OR Monthly 35d @ 2% 1y hard Lockup, 2.5y soft lockup @ 6%, 1/3 per year, 2/3 @ 6% with 20% gate Anniversaries, side pockets, side letters!

Liquidity of funds

20 40 60 80

Managed Futures
15

Fixed Income: Mortgage-Backed

Count

Count

0
0

10

31

60

90

120 150 180

60

130

210 Duration

390

Duration

Decoupled and disproportional to market liquidity

FoHF Liabilities
Duration of liabilities is structurally mismatched works in normal conditions
Fund of Funds

0
0 90 215

200

400

360 498 Duration

750

FoHF Run: Liquidity Crisis

100%

S Fund (MP=100%, GI=0%) - Redemption S Fund (MP=0%, GI=0%) - Redemption S Fund (MP=0%, GI=100%) - Redemption
80%

S Fund (MP=100%, GI=0%) - Still at risk S Fund (MP=0%, GI=0%) - Still at risk S Fund (MP=0%, GI=100%) - Still at risk
60%

40%

20%

0% Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12

Alpha vs Beta Agency

Fund of hedge funds are still required
Best managers are packaged as hedge funds Inc. regulation, accessibility, monitoring ....

But they failed in 2008 and 2011

Blocked assets by mismanaging liquidity: gated, suspended redemptions, restructured ... Sold Beta at Alpha price: questionable performance attribution Industry AUM reduced by 1/3 or more

Service Provider Brands

PB
>50%: J.P. Morgan and Goldman Sachs Administrators: BNY Mellon, GlobeOp and Citigroup gained share

June 22nd
Replication today Hedge fund industry today Indexation risk and benefits New Normal (Jan 2011) Stress and response Mind your tail and momentum

New Products and Markets

Single strategy replicators
Equity L/S, CTA, CB Reverse (short) index replication Tail protection products

Secondary markets
Collateral management

Yet Another UCITS

HFR (1Q 2012)

Births: 304
level not reached since 4Q2007

Deaths: 232
the highest since 240 in 1Q10 FOF continued to experience a contraction 64 closing while 34 launched; 4th consecutive quarter of decline in number

Fees rose slightly

Avg 1.63%/17.75%

Index XYZ?

The New Normal

(HFR 1Q12) Hedge fund performance dispersion increased over 4Q11, with the top decile of all hedge funds averaging a gain of over 20%, while the bottom decile of all funds declined by 28% on average.

Rear View

May 2012 Performance

Risk On/Off, HFT Style

Portfolio De-Construction

New Dawn

Tail Risk Products

Modern Performance Charts

(Un)Managed Account Platform

Leverage

Watch Out

Emerging World

Not a Game

Year 1

Shipping Performance
Navigate in the high seas of illiquidity
Liquidity

Counterparty

BetaHF
Capacity Fees

NB. Risk, optimisation et al quant tools irrelevant; even OpRisk considerations