Swisshedge q2 2004 PDF

2nd Quarter 2004
A Review on Developments in the Hedge Fund Market
The Impact of Institutional Investors

on the Hedge Fund Industry
Contents
Editorial | Dr. Kurt Lambert | Harcourt AG
Quarterly Review | Dr. Philipp Cottier | Harcourt AG
Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG
10
Investors View | Michael Busack | Absolut Research GmbH
17
Special Feature | Alexander M. Ineichen | UBS
22
Academic Literature Review | Jim Brandon | BAAM GmbH
27
Roundtable Discussion 2 Quarter 2004
32
Events | Harcourt Events 2004 | Upcoming Conferences 2004
35
nd
swissHEDGE 0
Impressum
swissHEDGE | 2nd Quarter 2004

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swissHEDGE is a quarterly publication of Harcourt Investment Consulting AG intended for informational purposes
and based solely on information and data supplied by either
investment managers or qualified third parties. No information contained in this review should be interpreted as a
solicitation for an investment and mention of a particular
manager or product under no circumstance represents an
endorsement of the product or the manager by the publisher.
A prospective client for any product or service mentioned
in this publication should independently investigate the
investment manager and/or service provider and consult
with independent, qualified sources before engaging in any
activity. Investors should also be aware that historical
performance numbers presented herein are not indicative
of future performance and furthermore, investments in
hedge fund vehicles involve significant risks, including loss
of capital. Opinions expressed in the publication are not
necessarily those of Harcourt and Harcourt assumes no
responsibility for the contents of contributed articles.
Harcourt Investment Consulting AG is a leading provider
of hedge fund solutions to institutional investors. For further
information concerning Harcourt and its services visit our
webpage at www.harcourt.ch.
Editorial | Dr. Kurt Lambert | Harcourt AG
Is there fee pressure for funds of funds?
By: Dr. Kurt Lambert | Harcourt AG

Today, there exists quite a peculiar situation
with respect to the fees charged by funds of
hedge funds. Conventional industry wisdom
predicted significant downward pressure on
funds of funds fees as a result of 1) an increasing number of suppliers (at last count, there
were over 800 suppliers of fund of funds services), 2) competition from low cost index providers, and 3) the increasing commoditization
of their products and services. However, for a
certain and important segment of the fund of
funds universe, we are witnessing quite the
contrary. These fortunate few cannot only
maintain fee structures, but they seem to be
almost unrestricted in imposing any number of
restrictive conditions on their investors.
Those fortunate few are the larger global
funds of funds houses which are institutional
in strategy, size, structure, and spirit.
Partly because of negotiation power and foresight, these
powerhouses secured valuable capacity rights which are
already key today but will be paramount tomorrow. Note
that having secured capacity in itself is irrelevant; it is
having secured quality capacity that is important. By
secured quality capacity I mean capacity with both the leading and proven hedge fund managers of today as well as
the leaders of tomorrow. Only a fraction of the over 7000
existing funds have the experience, track record, infrastructure and processes required to receive and manage the
huge current and expected inflows of institutional money.
Demand for access to these managers is growing much faster than the supply of quality managers, and this demandsupply imbalance ensures that those funds of funds with
capacity in these managers are able to demand a premium
and keep their margins.
But it is not only their secured quality capacity which
supports their fee levels, it is also because institutional
investors view these funds of funds as credible and solid
counterparties in an industry that is still perceived by
many as a unorthodox, free-wheeling boutique industry.
Institutional tickets of USD100m are certain to go to the
few funds of funds managing in excess of USD1b.

And so, is there fee pressure for funds of funds? Yes, in the
short term and for the unfortunate majority. The funds of
funds below a critical size will have difficulties raising institutional assets, meeting increasing fixed costs and negotiating capacity and will eventually face fee pressure. For
the fortunate few, as capacity is a structural feature of the
hedge fund industry, fee pressure will be kept at a minimum but only as long as the investable hedge fund index
providers are not able to demonstrate that the added value
of funds of funds (ai, persistent excess performance net of
fees) does not exist.
swissHEDGE 3
Hedge Fund Industry Commentary: 1st Quarter 2004 | Dr. Philipp Cottier | Harcourt AG
Hedge fund industry commentary: first quarter 2004
By: Dr. Philipp Cottier | Harcourt AG

General market environment in 1st quarter of 2004
The year 2004 started off on a very upbeat note
as many investors came to the conclusion that
the US and some other major economies were
poised for strong growth. At the same time,
there were no signs of inflationary pressure
on the horizon, providing equity markets with
the perfect backdrop of earnings growth and
low interest rates. Investors got a slight jitter
at the end of January with Mr. Greenspans
comments on the future, interpreted as being
a little less bullish for interest rates. Markets
managed to shrug this off quite quickly though
and continued upwards in February. Europe
followed suit and actually outperformed the
US during the first two months. Japan was
also in positive territory by February although
to a lesser degree. Emerging markets were
mixed; some Asian countries were hurt by the
avian flu while Eastern Europe rallied based
on excess liquidity.
But markets on both sides of the Atlantic were interrupted
in March by weak employment data in the US, the Madrid
bombing in Europe and overall geopolitical tensions.
Nevertheless, emerging markets continued on their
upward trend, especially in Eastern Europe. Japan also
showed a great degree of independence to other major
markets and rallied significantly. The first signs that deflation in Japan may be ending after a decade, set investors in
search for domestic reflation plays in both the banking and
the real estate sector. Overall for the quarter the MSCI
swissHEDGE 4
World, S&P 500, MSCI Europe and Topix indices returned

+2.18%, +1.25%, +2.86%, and +12.99%, respectively.
However, some major indices such as the Dow Jones and
the NASDAQ actually finished the quarter in the red.
Unlike last year, when technology was the best performing
sector, this quarters leading sectors had a more defensive
mix. Similarly to last year, however, across all major regions,
it was the small caps that outperformed the large caps (Russell
2000 +6%; MSCI European small cap +10%; TSE 2 +30%).
The first quarter of 2004 represented a key period for all
fixed income markets as evidence emerged of a stronger
US economic recovery and therefore of increased likelihood of higher interest rates and a bear market for sovereign
fixed income products. The risk of a deflationary spiral
receded as inflation trends bottomed, suggesting a narrowing
of the output gap. The recovery signs however did come in
spite of contradictory employment recovery direction, negative in March and strongly positive in early April. This in
turn generated both downside and upside yield curve
volatility which caught many hedge funds and traders offguard and contributed to generally muted returns. After
flattening for three successive quarters, the curve started to
steepen again. Relative value differentials expressed in the
form of option adjusted spreads remained tight across all
maturities. In addition, the overall level of spreads remains
low by historical measures suggesting an increase in the use
of leverage by relative value fixed income hedge funds.
Front end curve rates declined over the quarter highlighting the development of consensus for further delays in the
Feds hiking of interest rates, especially in light of the
volatile unemployment number. Overall, USD 3-month
interest rates increased slightly from 0.89% to 0.96%, while
USD 2-year rates decreased from 1.86% to 1.60% and the
10-year long end of the curve from 4.26% to 3.87%. In
Europe, short term rates decreased from 2.03% to 1.90%
Hedge Fund Strategy
Ret Q1 2004
HFR Funds of Funds

HFR Hedge Funds
CSFB/Tremont Hedge Funds
3.39%
3.53%
3.41%
Emerging markets
CTAs
Sector specialists
Distressed securities
Long/short equity
Macro
MBS arbitrage
Statistical arbitrage
High yield
Fixed income arbitrage
Market neutral equity
Merger arbitrage
Convertible arbitrage
Short-selling
9.54%
4.95%
4.78%
4.75%
3.26%
3.14%
2.62%
2.49%
2.40%
2.10%
1.99%
1.42%
1.23%
-3.81%
MSCI World
JPM Global Bonds
2.18%
1.97%
Source: Hedge Fund Research Inc., Barclay Trading Group Ltd.
while 10-year rates decreased from 4.30% to 3.94%.

Overall, the JP Morgan Global Bond Index gained +1.97%
in the first quarter, while the Pictet Swiss Bond Index was
up +1.83% and the Lehman Brothers High Yield Index
appreciated by a further +2.41%. On the currency front,
the US Dollar strengthened slightly against the Euro to
end the quarter at 1.22 (down 3 Cents). The JPY stayed
around 106, whereas the CHF weakened to 1.28 from 1.25.
Gold continued its rally to USD 420 per ounce, up from USD
416. Brent Crude Oil prices increased to USD 33 from 30.
Performance of hedge funds in 1st quarter of 2004
With the exception of the short-sellers, all hedge fund
strategies ended Q1 with a positive performance. The
quarter was led by the directional strategies (CTAs, long/
short equity, distressed, macro), followed by the relative value
strategies. Overall, from January to March 2004, the equalweighted HFR Composite Index was up +3.53% and the
asset-weighted CSFB/Tremont Index up +3.41%. The performance of the HFR Funds of Funds Index was up
+3.39%.
Directional Equity Strategies: The quarter was a relatively good one for directional equity strategies as the
relevant index delivered +3.26%, capturing most of the
upside produced by the stock markets. Markets seemed to
have started to reward quality stocks again and many
long/short managers went back to applying their stock picking skills. European focused managers outperformed their
US counterparts backed by strong markets and good stock
picking conditions. Japanese focused managers were
amongst the best performers (+6.46% acc. to AsiaHedge),
benefiting from enthusiasm on the local economy and a
huge bounce in small cap stocks. The best absolute performance was delivered by managers exposed to emerging
markets which increased by +9.54% on average. Within
that region, the Eastern European component was the
strongest at +20.04%.
Relative Value Equity Strategies: Convertible arbitrageurs
were up +1.23% in Q1. They faced a less buoyant trading
environment with credit spreads displaying softness, but valuations nevertheless increasing on the margins due to inflows
into the asset class. Over the period, the S&P investment
grade index widened from 164 to 169 bps and the S&P
speculative grade index widened from 767 to 860 bps. The
actual volatility of the S&P 500 index rose from 10.5% to
13.7%, providing some support to implied volatility levels,
with the US index increasing from 28.0% to 31.0% and the
European index flat at 32%. Primary issuance over the
quarter was reasonable in the US with an aggregate of
USD16b issuance, but dramatically weak in Europe with
only EUR1.7b of issuance. Large issues in the US included
XL Capital, Freeport McMoran and Israeli pharmaceutical
company Teva. Europe only saw one large issue in Anglo
Gold for EUR1b. The new issuance pace year-to-date is
clearly weak in regard to the demand of both outright and
hedged convertible investors.
Merger arbitrageurs were up +1.42% for the quarter. Deal
activity has seen a pick-up enabling managers to increase
their invested amounts, but deal spreads remain tight. The
first two months of the quarter were quite active. January
saw the JP Morgan purchase of Bank One for USD60b and
the French pharmaceutical giant Sanofi USD57b hostile
bid for Aventis. February saw further large deals with
Comcasts USD48b offer for Disney, the USD47b competitive bid for AT&T Wireless ultimately won by Cingular,
and a USD9b Oracle bid for PeopleSoft. March was quieter
with most activity in smaller deals, and private equity firms
such as Blackstone, Apex and KKR making acquisitions.
Statistical arbitrageurs were up +2.49% for the quarter.
Healthy trading volumes and market breadth provided fertile grounds for mean reversion strategies, with short and
long term models notably overperforming, while medium
term models provided more mixed results. Market neutral
equity managers were up +1.99%. The market ceased favor-
swissHEDGE 5
ing companies with high beta, low USD prices, and reverted
to employing more long-term investment rationales.
Earnings expectations and value factors made a strong contribution over the quarter.
Relative Value Fixed Income Strategies: The unsettled
US economic recovery, paired with generally tight option
adjusted spreads, forced fixed income arbitrageurs to deliver
moderate returns (HFR FIA +2.10%) on average. Relative
performance was differentiated among investing styles. In
addition to a limited set of domestic opportunities, mean
reversion focused managers have remained generally prudent
since the surprise widening of Q3 2003, when they experienced a considerable drawdown. More directional intermarket trade opportunities and relative value positions
with a directional component in either the shape or steepness were more abundant, providing support for macro
biased players to outperform their peers in the period. We
anticipate managers to develop a shorter bias as the economy
recovers and the curve steepens. Furthermore, after the
Spanish elections, and going into election time in the US,
the threat of coordinated terrorist action may increase, suggesting caution in global markets and relative value exposures. The volatility in interest rates, along with the renewed
political interest in the agency guarantee, contributed to
MBS arbitrageurs delivering moderately low returns (HFR
MBS +2.62%), despite sustained strong trading fundamentals
of low financing rates and a steep yield curve. The American
Senate Banking Committee decided to create a new regulator for the agencies. Notwithstanding the agencies sustained
lobbying convinced the Bush administration to postpone
the debate until after the election. The strong issuance of
mortgage related securities contributed to raise the size of
the MBS market to USD5.4tn vs. USD3.6tn for the US
Treasury market. Given current household, corporate and
sovereign sensitivity to interest rate hikes, we recommend
a prudent stance in this space.
Directional Fixed Income Strategies: The salient feature
of this quarter in credit sensitive strategies was the end of
the long rally in corporate fixed income products and their
derivatives. After record inflows, issuance and capital
appreciation, the tremendous flight out of quality in the
search for riskier yield stopped. Credit spreads for riskier
products reversed and experienced a widening that challenged most hedge funds that had become used to the
extended tightening. Investment grade products held their
ground and remained stable. The reversal announced the
start of a new cycle for rating related credits in which securities may trade sideways for as long as the economic recovery
swissHEDGE 6
lasts. Volatility may become more tame and bi-directional.

Long only indices reflected the slowdown helping the
Lehman Brothers High Yield index deliver +2.41% for the
quarter. Confronted with reversing trends in credit markets,
high yield funds delivered more moderate but reasonable
returns (HFR HY +2.40%). Both flow trading driven and
fundamental analysis driven funds will experience more
difficulty in finding opportunities. However, the large
amount of issuance by corporations capitalizing in credit
product attractiveness resulted in leveraged structures of
debatable benefit to corporate profitability. Going forward,
as interest rates rise and the burden of bad corporate
indebtedness becomes evident, leveraged entities may
experience stress which may open new relative value and
fundamental directional investment opportunities. This is
why, despite a slowdown in the performance of distressed
securities managers who delivered a strong performance in
January but flat in February and March (up +4.75% in Q1),
additional opportunities may arise during the year. As the
economy recovers and default rates decrease, while recovery rates continue to increase, we anticipate the sector to
continue delivering base line support performance below
the outstanding levels of 2003. Emerging market debt managers delivered another strong performance (up +9.54%)
despite the length of the sustained emergent market rally.
A strong US recovery will continue to provide base support
for the sector but may erode the inflows as investors return
capital to recovering G7 economies. Furthermore the negative accelerator effect on emerging market corporate
borrowing costs may increase downward pressure on an
asset class which remains very rich on a risk-adjusted basis.
CTA and Macro Strategies: CTAs recorded a strong performance ending Q1 up +4.95%. Currencies continued to
be the top performing sector, followed by the interest rate
and energy sectors. The major trends that dominated the
latter half of 2003 continued into early January as fixed
income and equity markets rallied. Both base and precious
metals dominated the headlines with price increases:
strong profits were made in copper and aluminum, and palladium rallied at the end of the month by nearly 6% in just
two days. During the last week of January, the Feds
announcement with regards to the Fed rate impacted the
equity and fixed income markets negatively. In February,
the downward pressure on the USD resumed, resulting in
strong gains in the currency sector. The USD dropped to
near record lows against most major currencies in the middle of February, but then strongly appreciated toward the
end of the month. Base metals, with the exception of
Nickel, continued their upward move and also performed

well. Declining inventories of base metals, in the face of
growing demand from the US and Asia, sent copper up
more than 17% for the month. Energy prices also climbed
when the OPEC declared that it would keep supplies tight,
despite low refinery inventories. Trends continued in the
grain markets based on strong exports demand and unresolved drought conditions in major growing areas. Finally,
March proved to be a very volatile month and most CTAs
posted only modest gains. Losses in financials were offset
by profits in the commodity sectors. In the currency sector,
the JPY surged when the BOJ announced its intention to
end its market interventions. The USD strengthened and
continued to consolidate against the EUR. Concerns regarding the sustainability of the US economic recovery adversely
impacted stock indices, and the terrorist attacks in Madrid
accelerated the correction. The energy sector rallied following the OPEC announcement to cut production, but energy
prices moved back up when the American Petroleum
Institute published larger supplies than expected.
The HFR Global Macro index returned +3.14% in the first
quarter of 2004, making it one of the top performing hedge
fund strategies for the quarter. The four pillars of global
macro (fixed income, equities, commodities and currencies)
each provided ample opportunities for profit, with volatility
rising in both the equity and fixed income markets.
Commodities and currencies experienced unusual turbulence and from this arose plenty of opportunities to capture
market directional moves.
Gold was held in unusually high quantities by global macro
managers and the price of this key commodity underwent
a rollercoaster ride of highs and lows. Many macro players
capitalized on the surge of demand from Japan and China.
For macro players focused on the G7 yield curve, there
were plenty of opportunities as the curve flattened and
steepened in an undulating fashion throughout the three
months. Swaption and cap volatilities were erratic through
the quarter, as were swap spreads and credit spreads. Two
unexpected US employment numbers (January and March)
added to the general uncertainty of the markets, a condition
which would be expected to benefit insightful global macro
managers.
Going forward, we remain bullish on European and Japanese
long/short equity funds, distressed securities and macro
funds. We are neutral on convertible arbitrage, merger
arbitrage, statistical equity arbitrage, fixed income arbitrage
and long/short US equity, as well as CTAs and long/short
high yield. MBS arbitrage is increasingly exposed to a rise
in USD interest rates, a weakening US real estate market, plus

a renewed agency debate post elections; hence an underweighting is recommended for cautious investors. We remain
negative on short-sellers.
Capacity
Estimates as to the size of the global hedge fund industry
vary, with some stating that hedge funds today manage as
much as USD1,000b in assets, excluding funds of funds.1
This is equivalent to roughly 1.3% of global stock and bond
markets combined. According to Harcourts estimates, the
average balance sheet leverage of global hedge funds amounts
to roughly 2.5:1 to 3.0:1. Furthermore, we estimate that
hedge funds are, on average, four times more active in
trading than other market participants (institutional
investors, retail investors, mutual funds, proprietary desks).
Thus, hedge funds currently account for about 15% of
trading volume of global financial markets. In other words,
hedge funds have become very important players globally.
Financial markets today would not work anymore without
the hedge funds, who have inherited the economic function of keeping the financial markets efficient and liquid.
The recent growth of the industry is expected to continue
over the next few years. Harcourt estimates inflows from
investors to be in the range of 10-15% pa. This, combined
with average hedge fund returns of 8-10% pa, yields an
annual growth rate of 20-25% pa. Such growth rates raise
the question about the capacity of the hedge fund industry.
In order to discuss capacity, one needs to look at both the
macro side and the micro side of capacity.
Macro side capacity of the overall hedge fund industry: Harcourt believes that in case the high inflows continue
and even accelerate, there will be capacity constraints in
certain strategies, particularly relative value oriented
strategies. However, directional hedge fund strategies will
be significantly less capacity constrained than relative value
strategies. The rationale for ample remaining capacity in
long/short equity goes as follows: in the equities world,
institutional investors are increasingly allocating to passive
as opposed to active equity mandates. According to several
sources, US & UK pension funds have up to 60% invested
passively already, and the amount is increasing. The more
the world invests passively, the more space will there be for
active investors. Since long/short equity hedge funds are
the ultimate prototype of the active equity investor, they
1 According to InvestHedge
swissHEDGE 7
Graph1 | Long term performance comparison

10000
1000
Hedge Fund Composite Index

JPM Global Bond Index
Dec 03
Dec 03
Dec 01
Dec 00
Dec 99
Dec 98
Dec 97
Dec 96
Dec 95
Dec 94
Dec 93
Dec 92
Dec 91
Dec 90
Dec 89
Dec 88
Dec 87
Dec 86
Dec 85
100
MSCI World Total Return Index
Source: MSCI; TASS; Hedge Fund Research Inc.
should remain only little capacity constrained, with the

exception of smaller cap players and funds engaging in less
liquid markets. Another directional strategy, trend-following CTAs, should also remain little capacity constrained
since there will always be trends2 and therefore, there will
always be capacity to engage in trend-following. There are
similar arguments in favor of sufficient capacity for most
other directional strategies, including macro hedge funds,
directional sovereign fixed income players and long/short
credit hedge funds. Relative value funds, on the other
hand, will have a much more constrained capacity environment to cope with. They trade spreads and arbitrage market
inefficiencies. Market inefficiencies are largely demand/
supply dependent. Since the demand for inefficiencies seems
to be increasing much more than the supply, spreads have
contracted across the board, leaving less juice for the
hedge funds than a few years ago. This is particularly the
case for quantitative market neutral equity, statistical equity arbitrage as well as merger arbitrage. The latter is an
example of a strategy where a continued scarcity of merger
deals is being met by an increasing appetite from hedge
funds (and hedge fund investors) for such deals.
Micro side capacity of individual hedge funds: Each
hedge fund strategy has a minimum, optimal and maximum
asset size. Beyond the maximum size, the assets become
increasingly difficult to manage and returns decrease. The
hedge fund managers find different ways to deal with
capacity: Many do a soft close once they approach their
optimal size, and then do a hard close once they exceed
their maximum size. Others enhance their capacity by deviating into other strategies and geographies, thereby becoming
swissHEDGE 8
multi-strategy funds. Yet others hire a whole stable of traders

to increase their capacity, some of which inhouse traders
and some of which trading from outside of the company.
For the funds of funds, the management of investment
capacity is absolutely crucial already today, and will
become even more critical going forward. Top tier hedge
funds are increasingly able to pick their clients, and going
forward only certain preferred investors will continue to
have access to these top tier funds. The way to manage
capacity for the funds of funds is to secure capacity agreements with the top tier funds on the one hand, and to
invest early stage in new hedge funds on the other hand.
Some funds of funds have gone as far as buying whole
hedge fund management companies. Capacity has become
highly valuable. As a result, Harcourt foresees more capacity brokers appearing as intermediaries in the value chain.
Furthermore, as a side effect there wont be as much pressure anymore on hedge fund fees nor on fund of funds
fees, because capacity will become dearer.
Return expectations
As can be seen in the graph above, historically hedge funds
have outperformed both stocks and bonds. Hedge funds
have been capable of catching a large part of the upside,
while protecting capital during difficult stock market periods. The question many investors ask is whether excess
returns can continue in light of the high inflows into the
industry. While absolute hedge fund returns have decreased
over the last twenty years, this was in a period of decreasing interest rates and stock market returns. In other words,
relative hedge fund returns, or excess returns, have remained
relatively stable and even increased over that period, as is
visible in the above graph. Also, the standard deviation of
hedge fund returns has generally decreased, so that on a
risk-adjusted basis, hedge fund returns have actually
remained quite consistent. Going forward, based on the
above comments on capacity, Harcourt expects returns to
decrease somewhat in capacity scarce areas (ie relative
value strategies), but does not expect return to decrease
significantly for directional strategies. Harcourt expects
future hedge fund returns to be similar to stock market
returns but with much lower volatility. Therefore, we recommend an allocation of 10-30% to hedge funds for
sophisticated, risk averse institutional investors.3
2 As emphasized by modern financial markets concepts such as Behavioural Finance.
3 Please refer also to our comments under Real alpha or just beta, Market Commentary,
Q3 2003; as well as How much should a risk adverse investor allocate to hedge
funds, Market Commentary, Q4 2003.
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How will institutional investors change the fund of hedge

funds industry?
A thing long expected takes the form of the unexpected when at last it comes. (Mark Twain)
By: Dr. Kurt Lambert, Marcel Herbst | Harcourt AG
Here they come: institutional allocations on

the rise
Introduction
Assets invested in hedge funds now represent
1.5% of global assets.1 It is the most widely
accepted estimate that global hedge fund assets
amounted to USD775 billion at the end of 2003,2
up around USD300 billion since the beginning
of the decade. As has been the case for years,
approximately 75% of these assets still come
from high net worth private clients and family
offices. Another 10% of the allocation is from
endowments and the remaining 15% from a
range of banks, insurers, and pension funds.
However, it is likely that this is about to change:
recent indications are that the often heralded
advent of institutional investors is finally here.
This article will document this trend and examine what institutional investors mean for our
industry in general, and for funds of funds in
particular. We conclude that our business will
be dominated by economies of scale but limited
by capacity constraints. Further, our industry
will increasingly resemble the mutual industry
with a few key differences.
swissHEDGE 10
A thing long expected. Alternative ways of investing

started to be explored by institutional investors since the
early 80ies. Real estate led the way in North America and
has since become a stable component of most institutional
portfolios worldwide. During the same time, private equity gained acceptance among North American institutions,
and continues to gain broader acceptance across the globe
today. While utilized by endowments and foundations in
North America for some time, hedge funds are still moving
from the periphery to the mainstream among most other
institutions.3
It seems like this move from periphery to mainstream is
accelerating; the number of institutions that invest in
hedge funds grew by an astounding 40% worldwide in
2003. Total commitments and average strategic allocations
also grew substantially in all global regions.4
A simple extrapolation illustrates how significant institutional investors can be: We expect the hedge fund industry
to develop at an annual compounded growth rate of 20% (a
result of inflows as well as performance) over the next 5
years, and that institutional investors will be the main driver
of this growth. Assuming that they will make up 50% of
assets invested in hedge funds by 2009 (up from 25%
Graph 1 | Percentage of European institutions currently investing in hedge funds

80%
67%
70%
62%
60%
60%
57%
48%
50%
47%
40%
40%
33%
30%
30%
20%
17%
20%
16%
17%
10%
7%
10%
0%
0%
France
Currently Investing
Germany
Italy
Netherlands
Scandinavia
Switzerland
UK
Total
Considering Investing
Source: Deutsche Bank 2003
today), institutional demand can (again, by 2009) be quantified to be close to USD1 trillion. This is about the same
size as the entire hedge fund industry is today.5
Where they come from. The institutional move towards
hedge funds varies in intensity across the globe. By the end
of last year, approx. a quarter of European institutions had
allocations to hedge funds (up from 15% in 2001) with
another 29% indicating that they intend to begin investing
in hedge funds in the next three years.6 In 2003, European
investors not only increased in number, but also more than
doubled their average strategic allocation to hedge funds.
This compares with North American institutions, who
increased both their overall commitment and average
strategic allocation to hedge funds by over 40%, and expect
to increase their strategic allocations further.
Graph 1 shows the European snapshot of investor indications per year-end 2002. One can extrapolate easily that the
growth from 2002 to 2003 was approx. 40% on average.
Who they are (not). Whereas the above might apply to
endowments, insurances, and banks, the proportion of
pension fund investment in hedge funds is still small, albeit
growing strongly. European pension fund allocations to
hedge funds increased to USD8b in 2003 from USD3b in
2002, according to Greenwich Associates. However, the
same pattern of growth is emerging: About 18% of the
European funds polled by Greenwich intend having hedge
fund allocations by 2005.8
Illustrating the historical hesitation of pension funds is the
fact that the average Swiss pension fund still the most active
of the European alternative pension fund investors only has
2% of their portfolios in hedge funds.9 There are some exceptions such as Nestls pension fund, who has raised its allocation in hedge funds to 18% of total assets invested, but these
seem to merely be the exceptions which prove the rule.10
Swiss pension allocations differ markedly from, for example,

UK pension funds. Historically having the largest exposure
to equities and hence the bear market, UK funds have only
this year shifted markedly towards bonds but are slow on
the hedge fund uptake. Watson Wyatt, the pension and
investment fund consultant, is encountering a surge in
absolute return mandates from UK pension funds. In 2003,
UK pension funds advised by Watson Wyatt awarded 16
absolute return mandates, more than double the seven
mandated to fund managers in 2002.
Why they are coming
At first glance, pick-up in institutional demand is not surprising: With their positive performance in the last few
years, compared with the dramatic destruction of wealth in
traditional equity linked investments, the non- and negative-correlation of hedge funds is finally taken seriously by
institutions. Add to this the catalyst of fiduciary and legal
1 Morgan Stanley Hedge Fund Report 2004. Reported by Infovest21 on April 05, 2004.
2 TASS, March, 2004.
3 Report on Alternative Investing by Tax-Exempt Organizations 2003, by Goldman Sachs
International & Russell Investment Group. Page 1.
5 Despite this being an enormous amount of capital, hedge funds will still be less than
3% of global assets by then.
6 Goldman Sachs press release on the Report on Alternative Investing by Tax-Exempt
Organizations 2003 report. Reported by Infovest21 on November 12, 2003.
8 Greenwich Associates Survey of Hedge Fund Allocations 2003. Reported by Infovest21
on January 27, 2004. Greenwich interviewed 2,475 institutional investors in the United
States, continental Europe, the UK, Canada, Japan, and Australia, and asked them
about their asset allocations and use of investment products, including alternative
assets.
9 Watson Wyatt News Release on Annual Report. Reported by Infovest21 on December 17, 2002.
10 Reported by Infovest21 on April 05, 2004. With the total size of the pension fund at
Nestle currently CHF 6.25 billion, the fund is currently investing around CH 1.13 billion
($860 million) in fund of funds.
swissHEDGE 11
Graph 2 | Classification framework of hedge funds vs.

stock and bonds
Expected return
Hedge Funds
Equities
Bonds
Risk
Source: Harcourt AG
responsibility on the part of trustees not to ignore investments that add value, and a form of moral dimension is
added to what might otherwise just have been a financial
empirical imperative to take hedge funds seriously.11
Despite last years buoyant equity markets, it is a fact that
pension fund balance sheets are still squeezed, and that
many are left under funded. As a result, and in order to
make their assets work harder, many funds are moving a
proportion of their assets away from benchmark-sensitive
instruments and making higher allocations to absolute
return products, notably to funds of hedge funds.12
The advantages of absolute return approaches over traditional investments have been examined and analysed manifold
and will not be repeated here in detail.13 Most frequently
cited reasons for investing in hedge funds center around
superior risk-adjusted performance, correlation, and diversification, all of which result in an enhancement of the
overall risk/return profile of a traditional portfolio. This follows the realization that hedge fund strategies provide
unique access to return opportunities under various market
environments that cannot be obtained from traditional
stock and bond investment.14
Another often cited attraction to hedge funds is that they

preserve capital in down-markets. These investors see hedge
funds not primarily as return drivers, but rather as diversifiers
and optimizers. Graph3 (below) demonstrates this capability
of hedge funds to provide downside protection in turbulent
markets.
Taking the advantages of hedge funds as a given, the question is how much to allocate to them in the overall context
of a portfolio. Much research on this topic has been done,
and we are also rather cautious on the allocations in excess
of 75% derived from classis portfolio optimizations. We
propose that investors ideally allocate 10% to 30% in order
to have a real positive portfolio effect, and believe that the
1% to 5% of assets that many institutional investors are
allocating are not sufficient.
The specific requirements of institutional investors
What do institutions need? Having worked almost exclusively
with institutional investors and their consultants since the
mid-nineties, we believe that the following is key.
High quality capacity. Frequently, institutions have significant amounts of capital to allocate. Just as frequently,
and because institutional decision making processes are
lengthy, detailed and therefore expensive, this capital is
allocated to a limited number of funds of funds. In order to
justify the expense and time required to select the appropriate manager, institutions require that incremental allocation
increases be deployed efficiently and with no distortion on
the desired risk/return expectations. Consequently, hedge
funds and (more importantly) funds of funds must be able
to provide sufficient amounts of high-quality capacity and
Graph 3 | Hedge Funds vs. MSCI World, 1990-2003

30%
20%
10%
0%
-10%
-20%
-30%
1990
1991
MSCI World ($)

Source: HFRI/FactSet
swissHEDGE 12
1992
1993
1994
1995
1996
HFRI Funds of Funds Composite Index
1997
1998
1999
2000
2001
2002
2003
Graph 4 | Main problems cited by European institutions

regarding hedge fund investment15
Graph 5 | Primary reasons investors require additional

transparency
40
100%
34%
% of these responding
35
27%
25
23%
20%
20
17%
74%
70%
60%
55%
50%
51%
38%
40%
15
12%
10%
30%
7%
20%
5
0
86%
80%
30
10
90%
10%
Liquidity
Lack of
Demand
High Fees
Lack of
Poor Image
Lack of Risk Control Lack of
Knowledge
Regulation
Transparency
Risk Monitoring
Strategy Drift
Monitoring
Leverage
Sector
Concentration
Cross Ownership
between Largest
Positions
be able to manage it appropriately as allocations increase.

Brand. Institutions want to invest with institutions is an
often heard statement suggesting that a hedge fund or
funds of funds needs to be equipped with size and brand in
order to receive institutional allocations. This follows the
need of institutions to avoid counterparty risk. We agree
that size confers stability, inasmuch as the recipient of capital is more likely to be able to provide the necessary infrastructure, allowing for risk management, detailed reporting,
etc, which in turn requires an asset base able to cover the
high (and increasing) fix costs. We do not know what the
minimum size is but expect it to be well above USD1b for
a fund of funds. At any rate, institutions like safe bets,
which begins and ends with whom the bet is placed with.
We believe that, therefore, length of track record, AUM,
shareholder structure, stability, compliance, and long-term
orientation of management and employees are the main
determinants for institutional asset raising success.
Transparency. One of the most often talked about problems with hedge funds is that they are intransparent.
Opinions vary as to what degree of transparency can be
provisioned or is useful,16 but it is clear that resolving the
black-box syndrome deserves increased attention. Several
recently released reports confirm that institutions who do
not yet invest in hedge funds are concerned foremost with
transparency and risk.17
Risk Management. Over the last few years, issues such
as risk containment have been at the forefront of investorsminds.18 We believe that, due to the non-normal nature of
hedge fund returns and due to the fact that alpha is such an
elusive measure, quantifiable risks do not explain all main
risks of hedge funds. In fact, it is the operational risks and
other hardly quantifiable parameters which indicate the
risk of investing in a hedge fund.19
Replicable and transparent processes. The strength of

structures and processes is what counts. This derives not
only from the point above on brand, but also has to do
simply with the way institutions work themselves. Higher
standards of process and compliance are called for as fiduciaries have to uphold Prudent Investor requirements,
adhering to high standards of due diligence and portfolio
monitoring.20
Know-How sharing. Hedge funds are complex. The strategies pursued are highly sophisticated, complicated, and
new to most institutional investors. Fiduciary responsibility
on behalf of the decision makers, as well as common sense,
dictates that one should only invest in what one understands. And it is the provisioning of this understanding
which is important. Indeed, we find that the longest lasting
relationships are built on transparency and the willingness
11 AIMA Journal, June 2003. Will Institutions Destroy the Alpha they Seek from Alternative
Investments? By Ian Morley, Dawnay, Day Olympia. AIMA.
12 Watson Wyatt news release, reported by Infovest21 on February 27, 2004.
13 An excellent introduction to hedge funds is In Search of Alpha by Alexander Ineichen,
published in October 2000. It is still, and rightfully so, the most widely read hedge fund
research piece today.
14 Alternative Investments in the Institutional Portfolio, Thomas Schneeweis, University
of Massachusetts, March 2002.
15 In the graph above (Main problems cited by European institutions regarding hedge
fund investing), it is interesting to note that liquidity is not a major concern for institutions
investing in hedge funds. Given the long-term time horizon of institutions, we likewise
have not found that limited liquidity is a major problem. In fact, institutional investors
have already accepted this limited liquidity with private equity and closed ended funds
and therefore this is less of an overall problem than it first appears.
16 Please see swissHEDGE, 3rd Quarter 2003: Transparency: A challenge for investors,
by Gianpaolo Schisano.
18 Interview with Divyesh Hindocha, worldwide partner and head of Mercer Investment
Consultings operations in Continental Europe. Reported by Infovest21 on January 27, 2004.
19 Some even believe that too much risk control, diversification, concern for liquidity, and
too much instantaneous measurement of co-variance will ultimately result in a profit
neutral position that may only produce a cash return. If that were the result of risk management, it was probably not worth bothering with it in the first place! See AIMA
Journal, June 2003. Will Institutions Destroy the Alpha they Seek from Alternative
Investments? By Ian Morley, Dawnay, Day Olympia. AIMA.
swissHEDGE 13
to educate investors about hedge funds. First the intellectual

connection, then the business connection.
What will change for the industry in general.
We believe that the advent of institutional investors will
change our industry greatly and require the willingness to
adapt for those interested in receiving institutional allocations.
Hedge fund fees will remain stable overall, but diverge.
We believe that Alpha, the financial word for talent, cannot
be bought at a discount. If Alpha truly exists (which we
believe it does), it is a rare commodity and one will have to
pay the going rate which is a premium to the commodity
rate. We are seeing today that the top hedge funds are not
only returning capital in order to maintain the optimal size.
Also, they are in a position where longer lock-up periods
and even increased fees are not deterring investors. The
cost of these payments is relatively small when measured
against the added-value of the return. Clearly, it is only
worth paying this premium if the Alpha is sustained over a
reasonable time horizon. This is probably the real challenge for the mediocre hedge funds, who often still get by
with charging the same fees as their established and successful counterparts. Their fees are likely to decline as
competition increases and as the industry moves from a
sellers market to a buyers market for these players.
Returns of some strategies will decline and increase
the value of capacity in other strategies. Barton Biggs
quote often cited is that the assets inflows into hedge funds
are endangering the golden goose, ai, that the sheer
amounts in assets will mean that the hedge fund industry
will arbitrage itself away. Clearly, spread-based strategies
with limited capacity, or strategies like merger arbitrage where
deal supply is currently outstripped by demand, are faced
with capacity limitations. On the other hand, macro and long/
short strategies are faced much less with these capacity
constraints. The result is that capacity constrained strategies
will decline in value, whereas other strategies will not.
Three preferred routes of allocating to hedge funds
will emerge. Do it yourself, investable hedge fund
indices, but mainly funds of funds. Large institutional
investors frequently choose to go on their own, ai, recruit
their own hedge fund teams and create their own expertise
in order to circumvent the pricey fund of fund middlemen.
An often cited example is Dutch pension giant ABP, who
built up an own team in New York to select single hedge
funds. Allocations to funds of funds are made only in niche
swissHEDGE 14
strategies where informational asymmetries are high (ai,

analysis expense high as well), investment allocations are
low, and where therefore it makes economic sense to pay a
fund of funds to do it. Drawing a comparison to the mutual
fund industry today, however, makes us believe that only
very few investors will decide to do it themselves. Rather,
they will develop their asset framework, figure out the
hedge fund strategies to which they want to gain exposure,
and then seek the best fund of funds to allocate to these
strategies. CalPERS, the worlds largest pension fund who
certainly would have the infrastructure required to allocate
to hedge funds directly, has chosen the fund of funds route
as preferred means of gaining access to hedge funds.
Second, the need of institutions for low-risk approaches and
benchmarking has given rise to investable hedge fund indexes, who are likely to become a major asset gatherer in our
industry. There, investor advantages are replicable processes,
low fees, rule driven investment decisions, representation and
more importantly what is perceived to be low counterparty
risk through well known brand names. FTSE, MSCI,
HFR, S&P have all joined the bandwagon and so far, indications are that these programmes will be successful.
Third (and most likely) choice: funds of funds.
and for funds of funds in particular
Funds of funds have grown from 18% of hedge funds in
2000 to 35% by the end of last year. Morgan Stanley expects
the funds of funds proportion of total hedge fund assets to
grow to over 45% within three years. Diversification, embedded advice, greater liquidity and disappointment with some
single name allocations are driving this shift, particularly
for first-time institutional clients.21
What is the impact of rapid industry growth dominated by
institutional investors to fund of funds?
More emphasis on capacity management. As mentioned before, capacity is key today and will be paramount
tomorrow. Demand will need to meet equal supply of the
same quality. Lack of capacity will negatively impact the
expected return profile, and therefore render the institutional analysis outdated. Risks and returns need to be
explained by market based factors and cannot be distorted
by the inability of a fund of fund to manage his capacity.
A simple example will illustrate how pronounced the capacity bottleneck is today: By definition, only half of all hedge
funds will be able to beat the other hedge funds in terms of
performance, on an asset weighted basis. Assume further
that hedge funds like to diversify their investor base and

have no more than 25% of their assets represented by one
single investor. This means that, based on industry assets of
USD775b per end of 2003, any single fund of funds cannot
invest more than USD97b in the hedge funds who are better
than average. Given that it is a fund of funds job to provide
returns over the average industry returns net of fees, and
that in reality funds of funds are incentivized to provide
much more than that, the real capacity bottleneck is with
the top quartile funds.
In that case, the maximum capacity available to any single
investor (if he is lucky to be able to get access to ALL top
quartile funds) is less than USD50b. Funds of funds are
heavily competing for this capacity. As a result, we believe
that there is a natural limit to the size of a funds of funds,
and that industry consolidation is inevitable. We also believe
that this is precisely the reason why high alpha capacity
is worth a premium, and that the fees of those providing it
will remain stable as long as performance does.
Table 1 | Illustrating the capacity bottleneck
Assets
(USDb)
Capacity to any single

investor (25% of fund
assets max.) (USDb)
Hedge Fund Assets Year End 2003
775
194
Top 50% hedge fund assets outperforming the average
388
97
Top 25% hedge fund assets (top quartile)
194
48
able to rapidly deploy cost efficient, best of breed structures

such as capital guarantees, leverage, options etc. in order to
comply with regulatory guidelines or investor preferences.
More links in the value chain will need to be captured.
Specialization within the value chain. If it becomes
reality that 45% of all assets invested in hedge funds flow
through fund of funds, then it will become a necessity for
funds of funds to differentiate and create sustainable competitive edges. We therefore believe that funds of funds
will need to evolve from due diligence driven providers of
plain vanilla products to highly specialized asset managers
who create alpha through active, unique and not replicable
selection of funds and strategies.
Competition and consolidation. Despite having just
begun, we believe that the race for institutional assets will
ultimately be won by just a few players. The maturing of
the market and the steep learning curve of the investors
will lead to substantial competition on all fronts. We
believe that the same scenario as in the long-only industry
today will apply for funds of funds tomorrow. The high
fixed costs associated with providing superior funds of
funds solutions will favour those who can deploy
economies of scale, which in turn means that big will be
beautiful (to a point, as illustrated in the example on capacity). There will be increased consolidation and only a handful of players will be dominating the industry.
Source: Harcourt AG
Conclusions
A consequence of the capacity bottleneck is that funds of
funds need to be very proactive in seeking capacity. Next to
securing capacity with the top hedge funds of today, this
implies an increased willingness to seed or invest in early
stage funds, where capacity can be obtained at favourable
conditions. Also, it implies that funds of funds need to increasingly take capacity constraints and other structural return
drivers into consideration when allocating to strategies.
Risk management. As Graph 4 shows, risk management
and reporting is important. Even though we believe that
quantifiable risks are not the main risks with hedge funds,
we recognize their measurement as a key demand which
the funds of funds community will need to increasingly
provide.
Structuring and product development. No two investors
are alike, which goes specifically for large institutions. The
fund of fund equation cannot only consist of strategy
selection + hedge fund selection + risk management. Fund
of funds must be able to dynamically adapt to varying
demands of the investors, which means that they must be
Thanks to funds of funds, the cultural divide between the

buttoned-up, highly structured institutional paradigm and
the unorthodox (as it is perceived) world of hedge fund
managers is slowly but surely closing.
As a result of increasing institutional demand funnelled
through fund of funds, these entities will come to dominate
the institutional hedge fund business. The expected growth
of the asset class, and the above-proportional growth of
funds of funds will lead to competition and consolidation.
Those funds of funds able to procure capacity, risk management, reporting and overall institutionalized processes
will be favored, and economies of scale will matter greatly
both in terms of the ability to provide for infrastructure,
but also in terms of the ability to obtain quality capacity.
20 Institutional or Institutionalized Are Hedge Funds Crazy?, by Putnam Lovell NBF,

December 2002. Page 39.
21 Reported by Infovest21 on March 22, 2004.
swissHEDGE 15
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Hedge funds in Germany 2004 what can German

institutional investors expect?
By: Michael Busack | Managing Partner of Absolut

Research GmbH | Hamburg
The German investment world is in a state of
flux. Following the events on the stock market
over recent years, institutional investors are
increasingly realizing that strategic asset allocation will be the biggest challenge facing them
over the next ten years. The new investment
act has made hedge funds the focus of attention for many investors seeking diversification
and new return opportunities.
A new era is dawning in the German hedge fund and asset
management industry. The new Investment Modernization
Act entered into force in January 2004. The Federal
German Finance Ministry has been busy drafting a new
investment act since October 2002 - one that also includes
hedge funds. It was no easy task to integrate this investment
form into an existing act, which - justifiably - imposes a
whole raft of restrictions on the investment fund sector in
an effort to protect investors. Many of the players involved
were skeptical up to the very last moment about the acts
chances of approval in its very liberal form. Representatives
of the Federal German Association for Alternative Investments (BAI), the BVI and also of foreign investment companies were last year involved in an endless series of meet-
ings with the Federal German Finance Ministry and the

supervisory authority. These proved that it is possible to
draft pioneering laws in a relatively short time, even in
Germany. Single hedge funds can now use the full spectrum of available strategies, but only in transactions with
institutional investors, or in connection with private placements for private investors. More or less every version of
hedge holding funds can be sold publicly.
The German hedge fund industry has been in a wait-andsee mode during the first weeks of the year 2004. This was
mainly because of legal and fiscal uncertainties on the actual
presentation of product ideas and formulation of contracts.
Many players are waiting for a sign from the financial services authority, BaFin, responsible for regulation of market
conditions. Now that the act has passed so rapidly through
parliament, the BaFin has to set the practical guidelines
and fill the dry legal text with life. This will not be an easy
task. Preparations for launch of products have been running at high speed, and the first hedge funds products have
appeared on the market in April 2004.
Products in Germany
Institutional investors in Germany already have a few single
hedge funds to choose from (see Figure 2), but demand for
these is still relatively weak.
There is a significantly larger number of holding funds prod-
swissHEDGE 17
Investors View | Michael Busack
ucts available to the institutional sector. The Absolut|report

names over eighty of these, which were on offer from the
investment companies listed in the table even prior to
2004. These numbers will increase.
Foreign companies have also launched the first insurancetype products in the form of fund-linked life insurance
policies which include some hedge fund investments. The
German insurance industry is still far away from entering
this market.
The BaFin in consultation with the BAI and the BVI is
still working hard at drafting specimen contract terms for
investment management companies and creating the internal
structural conditions for licensing and ongoing supervision
of the new hedge funds. The authority is faced with a truly
mammoth task that has to be performed in as short a time
as possible. But it will have to be done if Germany is to
avoid falling behind its European neighbors, especially
Luxemburg and Ireland, in its regulatory arrangements.
There is a risk that German issuers of hedge funds could
decide to found them in countries other than Germany,
where they would escape control by the BaFin.
Insurance industry and hedge funds

The future of hedge fund investments represents a challenge for the German insurance industry. Insurance companies want to, and should seize the new opportunities
offered by the Investment Modernization Act. Despite all
the public debate about whether and how private investors
should invest in hedge fund products, it should never be
forgotten that institutional investors are the primary target
group for hedge funds.
Insurance companies offering retirement pension products
bear a heavy responsibility for the security of the financial
investments managed by them. The high proportion of
shares built up by insurance companies during the stock
market boom of the late 1990s brought heavy losses that
were not compensated by other capital investments.
There are now indications that fixed-interest securities are
heading for hard times. Bonds carrying high-interest
coupons are maturing and have to be replaced by those
yielding lower interest rates. After several years at historic
lows, there is now a risk that interest rates will start to rise
strateg en
abso
ute
return
high
yie
d
Der
Absolut
report
die
erste
Publikation
news
hedge
funds
managed
futures
performance
fr Alternative
Investments
in Deutschland.
research
recht/steuern produkte
hedge
funds
private equity
news
www.absolut-report.de | Nr.7 | 08/2002 | ISSN 1616-5373
www.absolut-report.de | Nr.4 | 04/2002 | ISSN 1616-5373
18 interview
19 interview
Absolut report
Abs olut report
Nr.6 06/2002
Nr.6 06/2002
Abs olut repor
1 Short-Selling-Index - 1/1990 bis 4/2002

1600
Tech Bubble be ginnt
1400
1200
1000
800
Tech Bubble endet
Jul 1999
Jan 2002
Aug 2001
Jan 1997
Jun 1997
Feb 1999
Sep 1998
Apr 1998
Okt 2000
Dez 1999
Nov 1997
Mai 2000
Mrz 2001
Jun1992
Jul 1994
Jan 1992
Feb 1994
Okt 1995
Mrz 1996
600
Aug 1996
Venture Capital in Deutschland:

Lehren der Vergangenheit .............42
Gerade die Thematik der Leerverkufe hat in jngster Zeit fr viel Aufregung in Deutschland gesorgt.
Die einen verurteilen diese Form des Investierens, da Kursverluste produziert werden k nnen. Hedge Fund-Manager
nutzen sie, um auch von fallenden Kursen profitieren zu k nnen. Gerade noch wurde ein Leerverkaufsverbot in
kritischen Marktsituationen aus dem 4. Finanzmarktf rder ungsgesetz gestrichen. Alexander Ineichen, Head of Equity
Derivatives Research bei UBS Warbung, uert sich zur kontroversen Debatte ber Leerverk ufe.
Aug1991
Kriterien f r den Einsatz von

Alternative Investments innerhalb
der Verm gensverwaltung ............34
F r unser Haus haben wir noch eine zweite Lehre aus dem R ckschlag am
Aktienmarkt gezogen. Auf der einen Seite wurden wir best tigt in der strategischen Entscheidung, unser Fixed Income-Gesch ft durch die Akquisition
von PIMCO im Jahr 1999 auszubauen. PIMCO entwickelt sich im aktuellen
Marktumfeld ganz hervorragend.
Auf der anderen Seite haben f r uns Investitionen in die alternativen Investmentbereiche auch in der Vergangenheit schon eine groe Rolle gespielt.
Beispielsweise haben wir 1998 eine eigene Private Equity-Gruppe aufgebaut,
die Allianz Capital Partners, die direkt in Private Equity investiert. Sp ter
folgten Investitionen in den Fund-of-Fund-Bereich sowie in einzelne Private
Equity-Funds. ber die in der Allianz Private Equity Holding (AZPEH)
zusammengefaten Aktivit ten haben wir bereits einen substanziellen Betrag
unserer Assets investiert.
Im Jahr 2000 wurde dann die Allianz Risk Transfer in Z rich aufgebaut, die
sich mit Risikomanagement-L sungen befasst, die an der Schnittstelle der
Versicherungstechnik auf der einen Seite und der Kapitalmarkttechnik auf der
anderen Seite liegen. Dort werden erstens mit den Mitteln der Securitisation
Versicherungs- und R ckv ersicherungsrisiken abgedeckt, und zweitens Versicherungsrisiken kapitalmarktf hig gemacht.
Weiterhin haben wir im August 2001 ein Team von der Citigroup angeworben,
das dort unter dem Namen Le gion Fund ein Fund-of-Hedge-Fund-Gesch ft
betrieben hatte. Das Team setzt sich aus 20 Mitarbeitern zusammen, die von
San Francisco, New York und Genf aus operieren und nun diesen f r die Allianz
neuen strategischen Gesch ftsbereich Alternative Investments, insbesondere
das Fund-of-Hedge-Fund-Gesch ft, entwickeln. Dieses Segment hat f r uns
Priorit t. Nach dem Platzen der Blase an den M rkten hat sich gezeigt, dass
wir mit unserer strategischen Entscheidung richtig lagen, in alle diese Bereiche
zu expandieren.
Sep 1993
Anlageverhalten von
Pensionskassen und Stiftungen im
Bereich Alternative Investments Teil 1 Private Equity......................28
Faber:
Dez 1994
Mit einem Volumen von rund 1.200 Mrd. Euro verwaltet die Allianz Dresdner Asset Management, die
Vermgensverwaltung der Allianz Gruppe, das meiste Geld in Europa. Nach der ber nahme der
Fondsgesellschaften PIMCO, Nicholas-Applegate, Oppenheimer Capital sowie der Dresdner Bank ist Dr. Joachim
Faber dabei, das Asset Management der Gruppe weiter zu optimieren. Dabei will er neben den konventionellen
Gesch ftsbereichen Equity, Fixed Income und Retail auch Hedge Funds und Absolute-Return-Investments als strategischen
Gesch ftsbereich ausbauen. In dem folgenden Interview f r den Absolut|report gibt Dr. Faber seine Einsch tzungen
zum Thema Hedge Funds und Private Equity aus Sicht eines weltweit t tigen Finanzkonzerns wieder.
Welche strategischen Entscheidungen haben Sie getroffen?
Mai 1995
Interview
Axel H rger und Dirk P opielas,
Goldman Sachs .............................16
AR:
Okt 1990
Hedge Funds - Private Equity - Absolute Return
Alternative Investments
in Pensionsfonds .............................8
der Short-Seller hoffen einen Profit

davon zu tragen, indem sie das Wertpapier zu einem bestimmten Kurs
kaufen und zu einem h heren Kurs
verkaufen.
Die Strategien unterscheiden sich
in erster Linie in der Abfolge der
Transaktionen. Marktteilnehmer, die
glauben, dass eine Aktie berbe wertet ist, k nnen Leerverk ufe vornehmen, um von einer wahrgenommenen Kursabweichung gegen ber
dem tats chlichen wirtschaftlichen
Wert zu profitieren. Solche ShortSeller erh hen die Effizienz bei der
Kursfestlegung eines Titels, da ihre
Transaktionen den Markt ber ihre
Bewertung der zuk nftigen Kursentwicklung informieren. Diese Bewertung sollte sich im resultierenden
Handelskurs des Wertpapiers widerspiegeln. Arbitrageure tragen ebenfalls zur Effizienz bei der Kursfestlegung bei, indem sie Leerverk ufe
verwenden, um von Kursschwankungen zwischen einer Aktie und einem
derivativen Wertpapier, wie einem
wandelbaren Wertpapier oder einer
Aktienoption, zu profitieren. So kann
beispielsweise ein Arbitrageur ein
wandelbares Wertpapier kaufen und
einen Leerverkauf der zugrunde liegenden Aktie vornehmen, um von
der derzeitigen Kursdifferenz zwischen zwei wirtschaftlich hnlichen
Positionen zu profitieren.
Eine der wichtigsten Voraussetzungen f r einen Markt ist folglich das
Vorhandensein von K ufer n und Verk ufer n. Das heit, ein Markt muss
nicht homogen, sondern heterogen
sein. Eines der Ph nomene finanzieller ber treibungen (wie die j ngste
Internet-Blase gezeigt hat) ist, dass
es f r Short-Seller schwierig ist,
Aktien zu leihen und damit Leerverk ufe zu t tigen. Eine Blase ist eine
Abkehr der Kurse von ihrem inneren
Wert und wird durch ein Ungleich-
HFRI Short Selling Index
Abs olut report
Nr.6 06/2002
Der Absolut|report versteht sich als zentrale Quelle f r neutrale und

qualitativ hochwertige Informationen zum Thema Alternative Investments
in Deutschland. Er bietet in verschiedensten Artikeln Hintergrundinformationen ber die Bereiche Hedge Funds, Private Equity, Credits
und Absolute Return-Produkte. Geschrieben von Experten f r Experten.
Alternative Investments sind in der Lage, ein traditionelles Aktien-/
Anleihen-Portfolio st rk er zu diversifizieren und den Ertrag zu opti-
Nr.6 06/2002
Abs olut report
33 research
Alternative Investments Information
Anstieg um 44 % entspricht. F r das 3 Strategic Allocation to Private Equity

Jahr wird ein weiterer Anstieg um
10 %
30 % auf 4,7 % von den Investoren
7,5 %
erwartet. Das Wachstum bei Private
8%
7,3 %
Equity wird also vor allem von euro6%
p ischen Investoren vorangetrieben.
% of Total Fund Assets
Alexander M. Ineichen
Ich denke, dass das Platzen der Tech-Blase unter dem Strich positiv gewesen
ist. Die Ereignisse haben sicher eine ber treibung korrigiert, die wir immer
wieder in verschiedenen Zyklen in unterschiedlichen Segmenten sehen. Der
solidere Wert eines Fixed-Income-Investments wird nun nicht mehr v llig
verteufelt, wie es noch Mitte der 90er Jahre der Fall gewesen ist. Eine
ausgewogene Diversif ikation in der Asset-Allokation ist ein groer Wert,
insbesondere f r die Allianz. Das Wort Diversifikation klingt modern, aber
die Versicherungen haben mit dem Prinzip Mischung und Streuung schon
seit Jahrzehnten gearbeitet. Die Ereignisse der Vergangenheit haben gezeigt,
dass eine breite Diversifikation und eine realistische Einsch tzung der potenziellen Ertr ge ein ganz wesentlicher Bestandteil der Asset- Allokation sein
m ssen. Manch einer ist hier in den vergangenen Monaten auf den Boden der
Realit t zur ckgeholt worden.
sten erzielt, welche das Gesch ft der

M rkte erleichtern, indem sie tempor re Angebots- und Nachfrageschwankungen nach Wertpapieren
ausgleichen. Im gleichen Ausma
wie Leerverk ufe von Wertpapierfachleuten ausgef hr t werden, erh ht
sich durch solche Leerverkaufsaktivit ten tats chlich die Handelsnachfrage nach Aktien, die f r K ufer
zur Verf gung stehen, und verringert
sich das Risiko, dass der Kurs, der
von den Anlegern gezahlt wird, wegen eines zeitweiligen Nachfrager ckgangs k nstlich hoch ist.
Leerverk ufe k nnen auch zu einer
effizienteren Kursfestlegung an den
Aktienm rkten beitragen: Effiziente
M rkte erfordern, dass sich in den
Kursen s mtliche Kauf- und Verkaufsinteressen widerspiegeln. Wenn
ein Short-Seller auf eine Abw r tsbewegung eines Wertpapiers spekuliert,
stellt seine Transaktion ein Spiegelbild der kaufenden Person dar, die
dieses Wertapapier basierend auf der
Spekulation kauft, dass der Kurs
steigt. Sowohl der K ufer als auch
In Bezug auf Leerverk ufe bestehen

viele Mythen. Der von der Bundesregierung urspr nglich vorgeschlagene Entwurf zum 4. Finanzmarktf rder ungsgesetz enthielt eine
Klausel, die erm glichen sollte,
Leerverk ufe in Deutschland vorber gehend zu untersagen. Das Finanzministerium warnte davor, dass
Verzerrungen in den nationalen Finanzm rkten und -instituten in einem
stark integrierten internationalen
Finanzsystem eine Gefahr f r die
weltweite finanzielle Stabilit t darstellen k nnen.
Als Hauptfaktoren einer Instabilit t
wurden eine schwache Bankenaufsicht in offshore-Finanzm rkten sowie eine unzul ngliche berw achung der Risikopositionen bei
Hedge Funds genannt.
Durch Leerverk ufe prof itiert der
Markt von zwei wichtigen Aspekten:
Marktliquidit t und Effizienz bei der
Kursfestlegung. Erhebliche Marktliquidit t wird durch Leerverk ufe
von Marktexperten wie Marktmachern, Paketh ndler n und Speziali-
Leerverkufe eine berprfung
Apr 1993
Faber:
Sie haben innerhalb der Allianz Gruppe und der Allianz Dresdner Asset
Management die Verantwortung f r fast 1.200 Milliarden Euro. Damit sind
Sie in Europa der f hrende Asset Manager und einer der weltgr ten Player.
Welche Ver nder ungen ergeben sich nach dem Platzen der Technologie-Blase
und dem 11. September aus Ihrer Sicht f r die Asset Management-Industrie?
Mai 1990
AR:
Mrz 1991
Interview
Dr. Joachim Faber
Vorstand Allianz AG, M nchen
CEO Allianz Dresdner Asset Management
Alternative Investment
Informationen
fr den institutionellen Anleger
30 research
41 hedge funds
40 hedge funds
Nov 1992
Absolut report
Alternative Investment
Informationen
fr den institutionellen Anleger
Hedge Funds - Private Equity - Absolute Return
Paradigmawechsel
Markteinsch tzung eines LongShort-Hedge Fund-Managers ...........8
Interview mit Johan Groothaert
und Jean-Marie Barreau,
Deutsche Bank AG ........................16
Transparenz und aktives
Risikomanagement in Fund-ofHedge Funds-Portfolios T
eil 2.....26
Kriterien zur Auswahl
von Private Equity Dachfonds........34
Vor- und Nachteile von Managed
Accounts bei Hedge Fund-Investments
und dynamische Garantiestrukturen
f r institutionelle Anleger...............38
Absolute Return-Strukturen
Erleichterungen nach steuerlicher
Gesetzes nderung...........................44
4%
North America
Europe
8,1 %
4,7 %
3,6 %
2,5 %
3. Aufteilung nach Investment2%
bereichen
Vielfach wird in Deutschland der Be0%
reich des Venture Capital mit Private
2003 (forecast)
1999
2001
Equity gleichgesetzt. Dieser Teilbereich macht einen wichtigen, aber keinesfalls dominierenden Anteil von 4 Commitments by Investment Type
Private Equity aus. Die Befragung der
North America
Europe
Investoren zeigt ein deutliches Bild (s.
Grafik 4). Sowohl in Nordamerika als
27 %
28 %
auch in Europa ist der Anteil der Leveraged Buyouts mit jeweils 50 % am
50 %
50 %
gr ten. In Europa gefolgt von Venture
8%
Capital mit 28 % sowie 21 % Expan21%
10 %
sion Capital; d.h. fast zwei Drittel der
5%
Private Equity Investments in Europa
sind Later-Stage-Investments und dieLeveraged Buyout
Mezzanine Financing
Expansion Capital
Venture Capital
Other
nen nicht der Gr ndung und dem Aufbau junger Unternehmen. Im Gegensatz zu den Investoren in Nordamerika der Studie von 1999 hnlich wieder. Bild. Hier ist die positive Einsch tspielen spezielle Bereiche, wie z.B. Ob sich diese Einsch tzung allerdings zung von Venture Capital mit 42 %
Mezzanine Financing mit 1 % und halten wird, bleibt nach der Krise an noch gr er . Der Buy-out-Bereich
andere Formen mit ebenfalls 1 % kaum den neuen M rkten fraglich. Mit wei- wird nur von 28 % der Befragten als
eine Rolle bei der Anlageentscheidung tem Abstand f hren in der Gunst der der attraktivste Private Equity-Bereich
institutioneller Investoren.
Investoren in Nordamerika die Venture in den n chsten 3 Jahren eingestuft.
In Nordamerika sind Investments in Capital-Investments (29 %) und Le- Deutlich ist bei den europ ischen
Mezzanine mit 5 % in der Allokation veraged Buy-outs (19 %).
Investoren der Trend zu internationaenthalten, jedoch nur 10 % betreffen In Europa zeigt sich ein hnliches
len Engagements zu erkennen.
den Bereich Expansion Capital. Signifikant gr er ist mit 8 % der Anteil 5 Most attractive Investment Type 6 Most attractive Private Equity
Investments over next three years
sonstiger Private Equity Investments. over next three years
Europe
Venture Capital stellt, wie in Europa, North America
den zweitgr ten Anteil in den Portfo4
lios mit 27 % dar.
8%
6%
Interessant ist auch die Einsch tzung
9%
der Investoren f r die attraktivsten
38 %
19 %
42 %
Bereiche bei Private Equity ber die
13 %
n chsten 3 Jahre (s. Grafik 5). Hier
wird vor allem der Bereich Venture
28 %
32 %
Capital von 38 % der Befragten als
der attraktivste eingesch tzt, gefolgt
von Leveraged Buy-outs mit 32 %.
Leveraged Buyout
Mezzanine Financing
Expansion Capital
Venture Capital
Special Situations
Diese Ergebnisse finden sich auch in
Abs olut report
Quartal 2001 abgeschlossen, so dass

einige Abschreibungen, die aufgrund
der schlechten Marktsituation im
vierten Quartal eingetreten sind,
durch die Ergebnisse nicht abgedeckt
werden. Deshalb w rden die Ergebnisse sicher unterhalb der angegebenen Bandbreiten liegen.
Dennoch gaben die Investoren die
Nettoertr ge bei Venture Capital im
Maximum mit + 258 % p.a. und im
Minimum mit + 7 % p.a. an. Der
Median (50 % aller Ergebnisse, weniger sensitiv f r extreme Ergebnisse) liegt bei + 58 % p.a.. Signifikant
geringere Ertr ge waren in den anderen Bereich zu erzielen. Der Median f r Buy-out lag auf Basis der
Angaben der Investoren bei 15 %
p.a., Mezzanine konnte 18 % p.a.
erzielen und Expansion Financing
wies ein Ergebnis von + 32 % p.a.
auf.
56 % der befragten Investoren gaben
an, dass ihre Erwartungen hinsichtlich der Ertr ge erf llt wurden, wobei
bei 37 % die Erwartungen sogar
ber troffen wurden. F r die Zukunft
sind die Ausagen weniger optimistisch. Die Ertragserwartungen wurden reduziert.
F r den Zeitraum 2001 bis 2003 gaben die nordamerikanischen Investoren an, f r den Gesamtbereich Private Equity einen Ertrag von 15 % p.a.
zu erwarten. Als Benchmark verwenden einige Investoren den S&P 500
plus 300-500 Basispunkte oder den
Wilshire 5000 plus 500 Basispunkte.
Hier zeigt sich die Anlehnung von
Private Equity an den traditionellen
Public Equity Market.
In Europa liegen die Daten nur f r
den Gesamtmarkt vor (s. Grafik 9).
Dabei wird unterteilt in Gesamtertrag
seit Investment in Private Equity,
Ertr ge der Periode 1998-2000 und
in Ertragserwartungen f r die Periode 2001-2003.
Der Median-Ertrag f r die Periode
liegt bei 30 % p.a. und ist damit um

zehn Prozentpunkte h her als der
Ertrag seit Beginn des Investments.
Die Zukunft wird auch in Europa
konservativer eingesch tzt. Die Investoren gehen von einer Bandbreite
von 30 % p.a. bis 5 % p.a. aus, bei
einem Median von 21 % p.a., der
immerhin sechs Prozentpunkte h her
eingesch tzt wird als von den Investoren in Nordamerika.
Gut 90 % der Investoren in Europa
gaben an, dass ihre Ertragserwartungen im Bereich Private Equity erf llt
oder sogar bertroffen wurden.
Als Benchmark sind in Europa eher
der MSCI World-Index oder der FTSE All Share-Index plus 300-500
Basispunkte im Gebrauch.
Fazit:
Private Equity ist bei vielen der
befragten steuerbefreiten institutionellen Investoren Bestandteil des
Portfolios. Die Ertragserwartungen
wurden in der Vergangenheit erf llt
und sogar ber troffen, allerdings
sind die Aussichten weniger optimistisch.
Die Wachstumsraten von Private
Equity sind dabei, sich zu reduzieren und fallen im Hinblick auf den
Hedge Fund-Bereich zur ck. Es tritt
ein S ttigungsef fekt auf allerdings
h herem Niveau ein.
Dieser Effekt wird sicher auch dadurch verst rkt, dass die Investoren
nach st rk er unkorrelierten Anlageformen zu traditionellen Investments suchen.
Wie sich dies auf den Bereich der
Hedge Funds auswirkt, wird im
zweiten Teil des Artikels betrachtet.
Nr.4 04/2002
Private Equity:
Oberbegriff f r alle EigenkapitalAnlageformen: Venture Capital, Mezzanine und LBO. Beteiligungskapita
im weitesten Sinne, das direkt oder
ber Funds in illiquide Assets investiert wird.
Leveraged Buyout (LBO):

berwie gend fremdkapitalfinanzierte
Unternehmens bernahme.
Expanision Capital:
Wachstums- und Expansionsfinanzierung. Das betreffende Unternehmen
hat den break-even-point erreicht oder
erwirtschaftet Gewinne. Die Mittel
werden zur Finanzierung von zus tzlichen Produktionskapazit ten, Produktdiversifikation oder Marktausweitung verwendet.
Mezzanine Financing:
Finanzierungsmittel, die eine Finanzierungsl ck e zwischen Fremd- und
Eigenkapital in der Kapitalstruktur
insbesondere bei MBO/MBI f llen.
Special Situations:
Diese Rubrik beinhaltet Investments
zur Exploration von l und/oder Gasreserven sowie deren Weiterentwicklung, Investments in Nutzholzplantagen sowie alle Formen sog. ETIs
(Economically Targeted Investments)
d.h. Investments, die einen Bezug zu
geografischen, k onomischen oder
sozialen Aspekten aufweisen.
Nr.4 04/2002
mieren. Weltweit setzen daher immer mehr institutionelle Investoren

auf alternative Anlageformen. Fordern Sie unsere Informationen
und ein Probeexemplar an!
Absolut report
Private Equity-Definitionen:
Absolut Research GmbH, Hafentor 2, D-20459 Hamburg, Tel.: +49 (0) 40 - 33 39 68 34, E-Mail: info@absolut-report.de
Abs olut report
Investors View | Michael Busack
again during the coming years and this would adversely

affect the quoted prices of low-interest bonds.
Now that the act is on the statute book, the BaFin wants to
act. It is thinking in terms of a hedge funds quota of 5%
within the overall risk capital quota. The circular detailing
the changes in investment regulations has been expected to
appear at the end of the first quarter of 2004. The new regulations stipulate a hedge funds quota of 10% for insurance
companies (but the extended opening clause could increase
this). Current allocations are nowhere near this level. Not
even 1% of the cash administered by insurance companies
is invested in this area.
If the BaFin wants to assess the benefits offered by hedge
fund products, it will almost certainly be forced to revise
the risk stress tests that it recently proposed. These tests
called for alternative investment forms to be lumped
together with shares and put through a uniform loss scenario. This form of stress test yielded worse results for
insurance companies already holding fairly high proportions
of alternative forms of investment. There is a lot at stake
here for the German insurance industry. Hedge funds are
complex products that clearly require special expertise in
selection and control. Consequently, those responsible will
have to draft suitable internal rules capable of convincing
the BaFin that they are adequate to control and monitor
the risks inherent in hedge funds. The insurance industry
will obviously have to face its responsibility for managing
pension accruals.
Strong growth in hedge fund assets
Tass Research reports that the hedge fund industrys total
volume rose to slightly above USD750b in 2003. It also
estimates that managed accounts hold a further USD250b.
Thus, the total amount managed by the industry in 2003
was around one trillion US dollars. There are currently
some 6,700 hedge funds in the USA of which just under
1,700 are holding funds.
German issuers are now reporting strong growth in this
investment form. The business unit specializing in hedge
holding funds at Germanys Commerzbank has more than
doubled the volume managed by it over a short timeframe.
This has risen from a level of around EUR500m in July
2003 to EUR1.1b at the present time.
German investment companies are also planning to start
up in this field. At its annual press conference, FrankfurtTrust Investment-Gesellschaft GmbH announced that, with
the arrival of the new investment legislation, it was now
planning to enter the hedge fund market with both single

funds and holding funds.
The Allianz insurance company is also coming to the startingpost in a joint venture involving its holding fund management subsidiary Allianz Hedge Fonds Partners and DIT.
The Deutsche Bank fund subsidiary DWS is planning to
get EUR 1b invested in its hedge funds during 2004 and
Figure 1 | Fund of hedge funds providers in Germany
Allianz Hedge Fund Partners
American Express
Auda
Baring
Benchmark
BNP Paribas
Citigroup
Commerzbank
Crdit Agricole
Credit Suisse First Boston
Deutsche Bank/Deutsche Asset Management
Dresdner Bank
Feri
Financial Risk Managament FRM
GLG
Goldman Sachs
Harcourt
Hauck & Aufhuser
Heritage
HypoVereinsbank
JP Morgan
Lazard
LGT Capital Partners
Man Investments
Mellon
Merrill Lynch
Olympia
Partners Group
Pioneer
RMF
Socit Gnrale
Swiss Capital
Tremont
UBP
UBS Warburg
Unigestion
Unico/Union Alternative Assets
Vereins- und Westbank
Source: Absolut Research GmbH (www.absolut-report.de)
Figure 2 | Single-hedge funds in Germany

Arsago ACM GmbH - arsago Global Hedge I
Aquila Capital Concepts GmbH - Active Quantitative Capital Concepts
CAI GmbH - Copernikus Beteiligungs-AG
DWS Investment GmbH
Lion Advisors GmbH - Lion Global Opportunity Ltd.
Lupus alpha Asset Management GmbH - Lupus alpha Dynamic Design
OSV Financial Management GmbH - OSV Currency Fund Ltd.
Dr. Jens Ehrhardt Kapital AG - Erhardt Absolute Return Index
Weisenhorn & Partner Financial Services GmbH - European Pearl
Investment Ltd.
Source: Absolut Research GmbH (www.absolut-report.de)
swissHEDGE 19
has just officially launched DWS Hedge Invest Dynamic,

its first hedge holding fund. In March, investment company Lupus alpha launched the first ever German single
hedge fund, named Lupus alpha Dynamic Design. This
independently managed fund will initially pursue an
option-based single hedge fund strategy, and operate in the
form of a German fund available to the general public for
private placements and also as a restricted fund available
only to specific investors.
Problems facing institutional investors
A large number of comments from institutional investors
indicate that these still have certain reservations about the
German hedge fund market. Many believe that it will be
some years before Germany can assemble the necessary
expertise on hedge funds.
Many German investment management companies prefer
to obtain this expertise from foreign companies. DWS will
work closely together with Deutsche Banks hedge fund
team in New York. Union Investment will also rely on foreign expertise, working together with the Swiss Partners
Group which offers managed account solutions. The
Metzler Bank is offering a product from consultant Frank
Russell, and the German savings bank group subsidiary
Deka Investment is already selling certificates for funds
managed by the Man Group, the worlds largest source of
hedge fund products.
Conclusions
Viewed historically, hedge fund returns exhibit little correlation with conventional investment categories like stocks,
bonds, currencies and commodities, mainly because of the
totally different strategies used by them.
Consequently, hedge fund products can help to improve
the degree of diversification in institutional portfolios. It is
absolutely essential to make the asset management industry
more flexible and open it up so that it can yield absolute
returns. The year 2004 only marks the start of this process.
Germany needs alternative investment forms more urgently
than ever. Many institutional portfolios are currently at the
mercy of emotion-driven market movements and portfolio
managers are no longer prepared to accept this situation.
But it remains the responsibility of product developers and
managers to design good products that bring a genuine
increase in portfolio efficiency rather than constant
investor disillusionment.
swissHEDGE 20
The cash volume invested in hedge funds in Germany is

now believed to stand at around 15 billion Euro. A large
part of this is in the form of certificates. The year 2004 has
an estimated additional potential of as much as 10 billion
Euro. Whether this target is achieved will depend on the
products offered and the general market environment.
However, the market has remained extremely hesitant during
the first weeks of 2004. The main reason for this is the legal
and fiscal uncertainties still prevailing on the actual design
of product ideas and formulation of contracts. Many market
players are still waiting for a sign from the supervisory
authority for financial services, which is responsible for
drafting the basic regulatory conditions.
The insurance industry and the pension funds are also
urgently awaiting the new investment regulations for
implementation of the new law. The important thing here,
both for the sector as a whole and for the investors, is to
avoid the danger that the liberal provisions of the new
investment act could be shackled by restrictive regulations
issued by the supervisory authority. It will be necessary to
find a compromise between the provision of adequate protection of investors and insured persons and the interests of
the investors. The insurance industry needs additional investment forms that will help it diversify its capital investments
and make it less dependent on the stock markets and interest markets. The legislators aim was to let hedge funds play
a role in this respect. The year 2004, especially the first six
months, will be very important as a period during which a
German hedge fund industry is created. It now all depends
on the formulation of the regulations issued by the supervisory authority, which will show whether the legislators
liberal intentions are translated into practice.
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Special Feature | Alexander M. Ineichen | UBS | CFA, CAIA
Absolute returns - bubble or new paradigm?
By: Alexander M. Ineichen, CFA, CAIA, Managing Director

and Global Head of AIS Research of UBS Investment
Research and author of Absolute Returns (Wiley, New York)
Introducing the absolute return approach
The growth in hedge funds for both private
and institutional investors could possibly evolve
to be more than just a bear market fad. There
is little evidence to suggest that absolute return
investing (hedge funds) is not a growth story.
Growth in absolute return space is a mix of
capital inflow and capital gains. It has been
high over the past decade, and accelerated
since equity markets peaked in 2000 and
spiked last year. The absolute return industry (to use a more descriptive term than hedge
fund) seems to have preserved investors wealth
skilfully and prudently so far this decade. The
preservation of capital has been achieved during what is arguably one of the most difficult
periods in the history of capital markets.
swissHEDGE 22
In Ineichen Absolute Returns [2003a] we called the

absolute return approach the third paradigm of active asset
management. Calling the absolute return approach a new
paradigm is undoubtedly bold, but given the speed at
which (European) insurance companies ran into solvency
problems and pension funds have had their surpluses
severely reduced, its clear that the financial community
still has some way to go in asset management. It is very
unlikely that the huge allocations to long-only equities by
US and UK pension funds (essentially an extreme concentration of risk) is the pinnacle of investment wisdom.
One could argue that every industry has its own industry
life cycle. We believe the asset management industry is
about to move from its second stage into its third. The first
stage of the asset management industry was a holistic
approach. Individuals and institutions sought to generate
returns by balancing stocks, bonds, and cash in a single
portfolio. This approach was primarily implemented by the
trust department of the neighbourhood bank. This paradigm suffered two great weaknesses in our view: mediocre
returns due to the lack of specialisation and lack of manager
accountability. These weaknesses were the seeds that
enabled a whole new investment management industry to

grow, and a shift to the second paradigm: the relative
performance game.
With the relative return approach, clearly measurable passive
market indexes provided the benchmark against which performance could be measured and investment managers
held accountable. The second paradigm fits nicely with
modern portfolio theory (MPT) and seminal academic
work on performance evaluation. With a final push from
regulatory changes, the ERISA act of 1974 in the U.S. in
particular, the second paradigm firmly established its roots
in the United States and elsewhere.
However, the introduction of clear and meaningful performance evaluation highlighted one of active managements greatest weaknesses: poor performance. Beating
the benchmark became the focus of only a small minority
of managers outperforming the benchmark on a consistent
basis. Arguably the introduction of a market benchmark
can be blamed on further negative phenomena including
the focus on asset growth (as opposed to performance), and
the following of investment trends and fads rather than the
pursuit of contrarian strategies and sticking to a disciplined
investment approach. Above all we believe it can result in the
deliberate seeking of the average mean (that is, mediocrity)
as opposed to meritocracy, and a strong disincentive to use
risk management techniques to preserve investors wealth.
The absolute return approach on the other hand seeks to
solve some of the issues of the relative return approach.
Investors introduce an absolute yardstick against which
managers are measured. This avoids some of the pitfalls of
the relative return approach, namely index or peer-group
hugging, search for mediocrity, and misalignment of interests
between manager and investor. Under the absolute return
approach, active asset managers are hired and paid to
balance investment opportunities with an absolute measure
for risk. Their aim is to increase wealth during a phase of
tailwind and preserve wealth when the wind changes and
becomes a headwind.
This is a material departure from the relative return approach
where risk management is left to the end investor. The
difference in the two approaches is manifested most clearly
through the differing definitions of risk (see Table1.) Relative
return managers define risk as tracking risk, whereas absolute
return managers define risk as total risk. Risk management
of the former is driven by market benchmark, while risk management of the latter by a P&L (profit and loss account).
Defining risk as total risk means that it is the manager that
determines the investors risk, and not the market (or the
Table1: Different business models in the asset

management industry
Relative-return model
(marked-based)
Absolute-return model
(skill-based)
Return objective
Relative to
benchmark
Absolute,
positive return
This means:
Capture asset
class premium
Exploit investment
opportunity
Risk management
Tracking risk
Total risk
This means:
Capture asset
class premium
Preserve capital
Source: Ineichen [2003a]
benchmark). Put simply, it means capital appreciation is

welcome while capital depreciation is not. Unlike with
relative return managers, the paramount objectives of
absolute return managers are avoiding absolute financial
losses, preservation of principal, as well as actively managing
portfolio volatility.
Asymmetric Returns
Risk management is supposed to yield asymmetric returns.
What today is referred to as active management is really
passive, as it uses the same risk management techniques as
index funds, that is, a passive investment style. In our view,
the distinction between passive and active is merely the
magnitude of the tracking error constraint (see Table 1). If
risk management is passive, the return distribution of the
managed portfolio will be similar to that of the underlying
market. Putting it crudely: if volatility is at 10 percent, the
passive (or the so-called active) portfolio will have a
volatility of around 10 percent, with higher moment risk
characteristics similar to the benchmark. If volatility is at
50 percent, the portfolio volatility will be around that level
as risk is defined and managed relative to the market
benchmark. In other words, in our view, the benchmarked
long-only manager does not have a mandate to manage
total risk.
In Ineichen [2003a,b] we made the case for actively seeking asymmetric returns. By asymmetric returns we mean
a return distribution that is different to a normal distribution
or a distribution that can be captured by passively tracking
a market index. In an ideal world, all returns would be positive, that is, the distribution skewed to the right. One
assumption behind the concept of asymmetric returns is
that all investors prefer asymmetric returns over symmetric
returns. This assumption is based on the following three
notions which, we believe, are common to all investors.
swissHEDGE 23
The first two notions are from Markowitz [1952, 1959] and
the third from Kahneman and Tversky [1979]:
Figure 1: Asymmetrical versus symmetrical return profile

Average quarterly return during 17
negative quarters for MSCI World
Average quarterly return during 39

positive quarters for MSCI World
from capital depreciation is larger than utility from

capital appreciation.
If a manager defines risk relative to a benchmark, the portfolio will mimic the return distribution of the underlying
market benchmark. However, hedge fund managers are
not driven by market benchmark but by P&L (profit and
loss). This means risk is defined in absolute terms (we use
the term total risk). If risk is defined as total risk and the
investment process is driven by P&L, the manager will be
taking into account these three factors. From an investors
point of view, humorist Will Rogers brings it to the point:
Im more concerned about the return of my money than
with the return on my money.
Car without brakes
The most comparable strategy to long-only equity is
long/short equity. The HFRI Equity Hedge Index (equity
long/short managers) outperformed most equity market
indices on an absolute as well as risk-adjusted basis by a
wide margin. However, most long/short managers should
underperform long-only managers in momentum-driven
bull markets where all stocks increase rapidly. The long/
short manager should underperform because the short
positions are a drag on performance (for example, in liquidity-driven momentum markets as in the late 1990s).
However, when markets have only slightly positive or
negative returns, long/short managers have outperformed
the long-only managers, at least in the past. In other words,
long/short hedge funds underperform in strong bull markets
and outperform in bear markets. This means that if the
returns of the benchmark index are fairly normally distributed, the return profile of absolute return managers is nonlinear, that is, asymmetrical to the market. Figure 1 shows
the symmetrical returns of an equity index and compares it
with the asymmetrical return profile of a hedge fund index.
The graph shows the average quarterly returns of the
HFRI Equity Hedge Index when the MSCI World was
positive and negative, respectively.
The average of the 39 quarterly returns between 1990 and
2003 was 6.2%. The corresponding return for the HFRI
swissHEDGE 24
6.3
Average quarterly total return (%)
More return is preferred over less,

Certainty is preferred over uncertainty,
Losses weigh stronger than profits, that is, disutility
6.2
6
4
2
0
0.2
-2
-4
-6
-8
7.9
-10
HFRI Equity Hedge (18.4%)

MSCI World (6.5%pa.)
Source: Update from UBS [2000] (based on data from Bloomberg and Datastream)
Equity Hedge Index was 6.3%. The average of the 17 negative quarters was -7.9% and 0.2%, respectively. A bull
market is defined as a market period with more positive
returns than negative returns, hence the mean is positive1.
An absolute return strategy should not only have lower
average negative returns but fewer as a strategy that results
in a symmetrical return distribution, i.e., a long-only strategy.
The relationship between positive and negative returns for
the long/short index was 44:12, which compares to 39:17
for the long-only proxy.
The main reason why traditional funds do more poorly in
downside markets is that they usually need to have a certain
weight in equities according to their mandate, and therefore
are often compared to a car without brakes. The freedom
of operation is limited with traditional asset managers and
more flexible with absolute return managers. Another possible reason why hedge fund managers may do better in
down markets is that they often have a large portion of
their personal wealth at risk in their funds. Arguably, their
interests are more aligned with those of their investors.
This alignment, together with the lack of a relative measure
for risk, increases the incentive to preserve wealth and
avoid losses. That is not to say the relative fund managers
are any less committed; its just that they have to work from
a slightly different perspective.
Avoiding negative compounding
Downside protection is closely related to avoiding negative
compounding. A simple example may help illustrate the
importance of wealth preservation: If one loses 50 percent,
as various markets and stocks did during 2000-2002, one
Special Feature | Alexander M. Ineichen | UBS
needs a 100 percent return just to get back to breakeven.

That is, the positive return must be double the negative
return. We argue that downside protection from the investors
point of view and avoidance of negative returns from the
managers point of view are different sides of the same
coin. By allocating funds to an absolute return manager,
the end investor expects the fund manager to manage the
funds in an entrepreneurial fashion, that is, balance opportunity with risk.
Figure 2 summarises what we mean by avoiding negative
compounding. The figure shows the underwater perspective
of four indices, that is, the figure shows the index as a percentage of its previous all-time high. We then calculated
the potential recovery period assuming the three indices
under water recover at an annual rate of 8 percent per year.
In other words, if the Nikkei 225 index starts compounding
at 8 percent per year from February 2004 onwards, it will
reach its December 1989 high around 2020.
Figure 2: Underwater perspective and potential recovery period at 8%
at peak
Index as precentage of all-time high(%)
100
2008e
2020e
80
60
40
20
MSCI World
Nikkei 225
2025
2020
2015
2010
2005
2000
SMI
HFRI Fund of Funds Composite
that they were not hired by investors to lose money. The

fundamental difference between the two investment
philosophies lies in the aversion to absolute financial losses
and the definition of risk. Absolute return managers define
risk as total risk whereas relative return managers define
risk as tracking risk.
Conclusion
Source: Ineichen [2003a] (based on data from Bloomberg and Datastream)
The absolute return manager could argue that a long-only

strategy has nothing to do with asset management or risk
management. Absolute return managers want to make
profits not only when the wind is at their backs but also
when it changes and becomes a headwind. Absolute return
managers will, therefore, use risk management and hedging
techniques this is where the asymmetrical return profile
discussed earlier comes from. From the point of view of
absolute return managers, relative return managers do not
use risk management, and do not manage assets as they
follow benchmarks. They are trend followers by definition.
Both absolute and relative return managers would argue
A risk manager would argue that one cannot manage

expected return, but one can manage risk. Return is the byproduct of taking risk. We believe the asset management
industry could be in the process of moving in the direction
of hedge funds, that is, defining risk in absolute terms rather
than relative terms. In other words, the asset management
industry might be in the process of moving from the second
to the third paradigm, as outlined in the introduction. One
could also argue that the asset management industry is
moving back to an absolute return orientation (first and
1 Alternative definition of a bull market: Random market movement causing
the average investor to mistake himself for a financial genius.
swissHEDGE 25
third paradigm) and that the passion with market benchmarks (second paradigm) was only a brief blip in the industrys evolution. As Peter Bernstein [2003] puts it:
One of the problems with this market has been, particularly for professional managers, benchmarkitis on
the part of the clients. I think there are forces at work
that are going to break that down. One is the hedge
fund, which you can approve or disapprove of as an animal, but its focused peoples attention away from the
conventional benchmarks. This is a very, very important
development.
We believe that one of the main sources of confusion,
myth, and misrepresentation comes from the fact that relative
return managers have a different definition for risk than
absolute return managers. The former defines risk as some
form of tracking risk (probability of deviating from a market
benchmark) while the latter defines risk as total risk (probability of losing money). Defining risk as total risk means
that it is the manager that determines the investors risk,
and not the market (or the benchmark). Among the pivotal
objectives of absolute return investing are, unlike with
relative return investing, avoiding absolute financial losses,
preservation of principal, as well as actively managing portfolio volatility. One of the major disadvantages of all this is
that the absolute return approach does not fit as nicely into
the asset allocation process of the institutional end investor.
One could conclude that the absolute return approach is
not fit for survival because there is limited transparency
and one cannot budget for risk as well as with the relative
return approach. We believe that this view is similar to the
assessment of individual transport one hundred years ago.
Because of the lack of proper roads, there was the belief
that the horse is here to stay.
In 2001 and 2002, there was the fear that money would be
pulled from the hedge fund industry as soon as the equity
market started to rise again. However, last year we experienced a first indication that this is in fact unlikely to happen. Not only did large parts of the 2001-02 inflows remain
in absolute return space, new money followed, eventually,
resulting in the spike of capital inflow in 2003. This was
despite equity markets rallying (temporarily). We believe
large parts of this capital buy into the absolute return
investment philosophy and not, or to a lesser extent, into
historical returns. If investors were buying historical returns,
we would argue that the growth is more cyclical and less
structural. We believe, however, that the main driver of the
swissHEDGE 26
growth is a sustainable change in the perception of risk. In

other words, short-term volatility matters to the long-term
investor.
Endnote
This article draws on material from UBS [2000, 2003], and
Ineichen [2003a,b]. The views and opinions expressed in
this article are those of the author and are not necessarily
those of UBS. UBS accepts no liability over the content of
the article. It is published solely for informational purposes
and is not to be construed as a solicitation or an offer to buy
or sell any securities or related financial instruments.
References
Bernstein, Peter L. (2003) Words from the Wise, CFA Magazine, AIMR,
Inaugural issue, January/February.
Ineichen, Alexander M. (2003a) Absolute Returns Risk and Opportunities
of Hedge Fund Investing, New York: John Wiley & Sons.
Ineichen, Alexander M. (2003b) Asymmetric Returns and sector Specialists,
Journal of Alternative Investments, Vol. 5, No. 4 (Spring), pp. 31-40.
Kahneman, Daniel, and Amos Tversky (1979) Prospect theory: An analysis
of decision under risk, Econometrica, Vol. 47, pp. 263-29.
Markowitz, Harry M. (1952) Portfolio Selection, Journal of Finance, Vol. 7,
No. 1 (March), pp. 77-91.
Markowitz, Harry M. (1959) Portfolio Selection: Efficient Diversification of
Investments, New York: John Wiley & Sons.
UBS (2000) In Search of Alpha Investing in Hedge Funds, Global equity
research, UBS Warburg, October.
UBS (2003) Fireflies before the Storm, Global equity research, UBS
Warburg, June.
Optimal mixing of hedge funds with traditional

investment vehicles
Papers by:
Noel Amenc, Professor of Finance at EDHEC Graduate
School of Business, Paris, France
Lionel Martellini, Asst. Professor of Finance, Marshall
Graduate School of Business at the University of
Southern California
Reviewed by Jim Brandon | BAAM GmbH
jim.brandon@baam.ch
Introduction
Most hedge fund (hereafter HF) investors do
not invest 100% of their assets in hedge fund
portfolios (hereafter HFP). Usually, investors
must choose a portfolio weight for each of several asset classes, the so-called asset allocation
decision. Existing financial research offers many
alternative methods but little overall perspective to help investors understand their relative
strengths and weaknesses. Before reviewing
the paper by Amenc & Martellini (hereafter
AM), it may be useful to briefly review asset
allocation methods for traditional asset classes.
For simplicity, I will refer to an asset allocation for two asset classes, stocks and HFs, in
addition to cash.
Single period mean-variance optimization (SPMVO)

The most well known method for asset allocation is the single
period mean-variance optimization, first studied by Harry
Markowitz in the early 1950s. His dissertation was criticized by Milton Friedman, a member of his dissertation
committee, as being merely mathematics. Following graduation he did not become a professor but worked at RAND
in Santa Monica, California. It is perhaps ironic that early
resistance to single period mean-variance optimization
(hereafter SPMVO) has given way to the current addiction
to this method, despite its many limitations. To understand
these limitations, imagine a world which is consistent with
the assumptions underlying SPMVO:
1. a stock portfolio (hereafter SP) and a HF portfolio with
jointly normally distributed returns
2. the means, variances and covariance are unchanging and
known with certainty
3. no trading costs
4. a constant riskless asset, i.e. cash
5. no taxes
In this world, a rational investor would select the optimal
asset allocation (three portfolio weights for SP, HFP and
cash) in the standard way, by investing in the tangency
portfolio (a combination of SP and HFP) and borrowing or
lending cash to choose the level of desired risk.
swissHEDGE 27
Clearly, this imaginary world is not the real world. The first
assumption above is seriously violated by real world HFP
and SP returns. Even if SP returns were normally distributed
(they are slightly fat tailed), HFP returns are much more
fat tailed than SP returns and negatively skewed. In addition HFP returns are co-skewed and co-kurtotic with SP
returns. It is well known that the tangency portfolio in an
SPMVO of an HFP and an SP often has a weight of 100%
in the HFP and a zero weight in the SP. Perhaps one reason that most investors do not follow this recommendation
(ai, invest only in the HFP) is that they are concerned
about the non-normal characteristics of the HFP which the
SPMVO ignores. (One might try to theoretically justify
SPMVO by arguing that investors have quadratic utility, i.e.
that investors only care about mean and variance.
Consistent with investor reluctance to invest only in HFs,
quadratic utility has a number of properties that are not
consistent with investor preferences.)
The second assumption above is also seriously violated by
real world HFP and SP returns. Although SPMVO is not very
sensitive to errors in variances and covariances, past evidence
shows that variances and covariances can change dramatically over time; particularly, large increases in covariances during
periods of large negative returns frequently occur. More
importantly, SPMVO is extremely sensitive to errors in
means (expected returns), and means require far longer
periods to estimate accurately. There is strong evidence that
the means of SP returns change over time, thus the common
method of using historical means as proxies for expected
returns will result in significant errors. HFP estimated
means suffer from this source of error also but, even worse,
they also suffer from sample selection biases (e.g. survival
bias and instant history bias) that can cause estimation errors
as high as 6% per annum in HFP expected returns.
The third assumption may seem innocuous at first sight but
the no-trading-costs assumption implies the ability to trade
at any time at no cost. HFs often have lock-ups, long redemption notices, limited redemption frequency (e.g. quarterly)
and early redemption penalties. The costs of such trading
limitations have been estimated in other contexts and
found to be quite large. The fourth and fifth assumptions
do not appear to be important sources of error when
SPMVO is applied to an HFP and other asset classes.
had certain knowledge of the joint distribution of the HFP

and the SP and a clear understanding of his or her utility
function, the investor could maximize expected utility. This
approach does not rely on the joint normality assumption.
Also, if the investor had a sufficiently long time horizon,
trading costs would be a less significant problem. But
certain knowledge of the joint distribution does not exist
and, as noted above, past historical returns alone are not
sufficient to estimate the joint distribution. An investor
with an expertise in HFs might combine his or her own
information with past returns to generate an improved
estimate of the joint distribution and hope that the resulting
portfolio weights were not seriously affected. Alternatively,
an investor could rely on HF advisors. Unfortunately,
although HF advisors often display skill in selecting HFs,
survey evidence indicates that many HF advisors lack the
quantitative and financial economic expertise required to
add value to the HFP-SP-cash asset allocation decision.
An idealized asset allocation
Amenc and Martellini (hereafter AM) cover a wide range

of issues more or less associated with the optimal allocation
of HFs to a traditional portfolio (e.g. stocks and bonds).
The paper mainly brings together results from other
So how might our now skeptical investor ideally optimize a

portfolio consisting of HFP, an SP and cash? If the investor
swissHEDGE 28
Other difficulties
Thus far I have said little about the HFP referred to above.
For the SP, an investor could choose a market weighted SP,
arguing that the stock market is roughly information
efficient. But the HF market is probably far from informationally efficient, especially since HFs often are exposed to
risks which are difficult-to-measure. Thus, it may be
unwise for an investor to simply choose a passive aggregate
HF index as the HFP in the asset allocation. Most investors
do not have the expertise to optimize a HF portfolio since
it involves many of the same difficulties discussed for the
asset allocation decision above (non-normal returns,
unknown distribution parameters, and trading costs), as
well as additional difficulties. For example, HFs are not
correctly viewed as a single asset class since HF strategies
differ by security market, risk factors and trading frequency.
Also, investment opportunities vary quite significantly over
time in the HF market. Ideally the asset allocation between
an HFP, an SP and cash would hedge against changes in
these investment opportunities, to lessen the volatility of
the portfolio return.
On to the review
research, but there are some new empirical results. The

following discusses and offers some perspective to their
results.
returns to move the mean variance efficient frontier for

stocks and bonds significantly upward.
The risk-reducer HF strategies have lower uncondiConditional diversification (or diversification

during falling markets)
AM conjecture that part of the popularity of HFs is due to
their exposure to alternative risks (e.g. credit risk, liquidity
risk, volatility risk) which offer diversification potential in a
portfolio of traditional market risks such as equity factors
and interest rate factors. In particular, they argue that
investors might be more willing to take on alternative risks
since correlations across international stocks during crisis
periods have increased over recent years. To provide
evidence on this conjecture, they present conditional
correlations of various HF strategies with the S&P 500.
The three conditions are periods when the S&P 500 is rising,
stable and falling. They find that correlations for 8 out of
the 12 HF strategies increase when the S&P 500 is falling
and decrease when the S&P 500 is rising. Only short selling
and market timing offer favorable diversification during an
equity crisis, that is falling correlations when the S&P 500
is falling. Unfortunately, this evidence is somewhat weak.
They note the hazards of conditional correlations (since the
falling and rising S&P 500 periods have, by selection, low
and high mean returns) but, as they are aware, correlations
estimates are very imprecise if the joint distribution is
non-normal. Also, the measured monthly correlation
between the S&P 500 and a HF holding options on the
S&P 500 may not be high, since options are a non-linear
function of the underlying security.
Unconditional diversification (return-enhancers and risk-reducers)
Noting the large differences across HF strategies regarding
the correlation with the S&P 500 (as well as the Lehman
US Bond index), AM argue that HFs are not a single asset
class, but numerous asset classes with different risk factors
that may offer diversification potential. They divide the HF
strategies into two groups:
The return-enhancer HF strategies have higher

unconditional correlations with stocks and bonds (distressed securities, emerging markets, event driven,
global macro, equity hedge and equity non-hedge). AM
argue that these HF strategies offer sufficiently high
tional correlations with stocks and bonds (convertible

arbitrage, fixed income arbitrage, market neutral,
short-selling, market timing and relative value). AM
argue that these HF strategies contain risks that are
sufficiently low to move the mean variance efficient
frontier for stocks and bonds significantly to the left.
Before considering their results, it is worth reminding
ourselves of the ever present potential for data-snooping
biases in HF analyses. It is conceivable that the diversification
potential of HFs has been a bit of luck. It is also conceivable
that the risk-reducer and return-enhancer strategies
have benefited from the same luck. The recognition of
these characteristics of HFs after the data have been
collected is quite different from the prediction of these
characteristics in 1990. And, as always, we must bear in
mind the limitations of mean variance optimization for
HFs. Thus, not surprisingly, the two graphs show the now
familiar improvement of the efficient frontiers. The return
enhancer strategies shift the frontier significantly upward,
although the amount varies significantly by strategy. The
risk-reducer strategies shift the frontier significantly to
the left, again with variation by strategy.
Since AM emphasized the role of alternative risks in the
diversification potential of HFs, they present the correlations between HF strategy portfolio returns and the
returns on the following alternative risks:
Risk factor
Proxy
Volatility
% change of VIX, a volatility index based on implicit volatilities of

large cap stocks
Exchange rate
% change of the USD relative to a basket of other currencies
Raw materials
% change in the price of a barrel of crude oil
Liquidity
% change of the trading volume of securities on the NYSE
Default
% change in the spread between Moodys-rated Baa and Aaa bonds
Yield curve slope
% change in the spread between a 30-year US Tbond and a 3 month

US Tbill
Interestingly, the correlations between the various HF

strategies and volatility risks are consistently fairly negative,
yet the correlations between the various HF strategies and
the other alternative risks are close to zero. For volatility
risk, the correlations are as follows: Market Neutral -0.02,
Short Selling +0.37, and ranging from -0.31 to -0.57 for
other ten HF strategies. Of the 60 remaining correlations
swissHEDGE 29
(12 strategies and 5 risks), all but two are between -0.20
and +0.20, and the remaining two are below +0.30. Perhaps
this is evidence of the difficulties of measuring the dependency of HF returns on risk factors with correlations, if joint
distributions are non-normal.
It is worth mentioning that the argument that HF investors
benefit from the diversification potential of alternative
risks is seriously weakened if investors can invest in alternative risks directly, avoiding HF fees and risks. I believe
that it would be relatively simple and inexpensive to invest
in five of the risk factor proxies above.
Diversification within a HF portfolio
AM finally move beyond mean and variance in addressing
the issue of how many HFs are required to fully diversify a
HF portfolio (HFP). They cite a number of results from
Learned and LHabitant (2002) (hereafter LH) who form
equally weighted portfolios of HFs selected randomly from
a large sample. LH repeat the simulation thousands of
times for portfolios with varying numbers of HFs and
report the sample statistics for the returns of the HFPs. As
expected, some measures of risk decline as the number of
HFs in the portfolio increase, in particular mean, variance
and some down-side risk measures. But the bad news is
that other (estimated) risk measures actually increase. For
some strategies, increasing the number of HFs in the HFP
reduces positive skewness, increases negative skewness
and increases kurtosis. And curiously, the correlation of the
HFP with the S&P 500 sometimes increases with the number
of HFs, a phenomenon that AM call diversification
overkill. LH distinguish between diversification across
style (style diversification) and diversification within style
(judgment diversification), concluding that the benefits
from the former are much larger than the latter.
Diversification benefits of adding HFs to a stock
portfolio (Mean Variance)
Strategic asset allocation usually refers to the long-run
asset class weights of a portfolio, with the recognition that
these weights might temporarily be altered to benefit from
a short-run opportunity (tactical asset allocation). This is
the same question we addressed in the introduction to this
review; what portfolio weight is invested in a stock portfolio
(SFP), a HF portfolio (HFP) and cash. To answer this question, first AM use a mean variance optimization and start
by considering the problem of estimating the mean returns
swissHEDGE 30
of SP and HFP, citing two well-known results. First estimates of variances and covariances become more precise
with more frequently observed returns (e.g. from monthly
to daily) but that, unfortunately, the precision of the estimates of means is unchanged by more frequently observed
returns. Second, to make matters worse, the estimate of
the efficient frontier in a mean variance optimization is
very sensitive to errors in means, and less sensitive to errors
in variances and covariances. In other words, the improvement of the mean-variance efficient frontier that is promised with an in-sample optimization may not be delivered
when the portfolio weights are applied to future (out-ofsample) returns, in particular due to estimation errors in
the mean returns.
AM duck the problem of estimating means by only estimating the minimum variance portfolio, which is only a
function of variances and covariances. In other words, this
is the only point on the efficient frontier that is unaffected
by the estimation errors of mean returns. AM are also careful
to present out-of-sample results, noting that they are not
aware of a study of the diversification benefits of HFs that
is not in-sample only. Their choice of portfolios to include
in the mean-variance optimization is as follows:
The traditional equity portfolios are S&P 500 Growth, S&P
500 Value, S&P 400 Mid-Cap and S&P 600 Small-Cap. Only
equity-related HF strategy portfolios are included: Dedicated
Short-Bias, Equity Market Neutral and Long-Short Equity
(all from CSFB-Tremont). The decision to limit the HF
strategy portfolios to equity-related is a bit strange a first
sight, since AM have argued that exposure to alternative
risk factors is one source of diversification benefits. It
would have been useful if they had included all the HF
strategy portfolios and some traditional bond portfolios as
well. If degrees of freedom were too scarce, then a single
equity and bond portfolio could have been substituted.
AM estimate the variance/covariance matrix using 48 months
of returns and then calculate the return of the minimum
variance portfolio for the next 6 months. The window is
moved forward 6 months and the estimation repeated.
Their out-of-sample results extend for just 24 months, from
Jan-99 to Dec-00. Presented below are the out-of-sample
annualized returns and standard deviations for the minimum variance portfolio, as well as the S&P 500 and an
equally weighted portfolio (equal weights in the four S&P
portfolios and three HF strategy portfolios included in the
optimization).
Although the three portfolios have about the same mean
return, the standard deviation of the minimum variance
Annualized Mean Return
Annualized Standard Deviation
Minimum Variance Portfolio
12.46%
2.02%
Equally Weighted Portfolio
12.66%
9.62%
S & P 500
13.16%
17.67%
portfolio is dramatically lower than that of the other two

portfolios. AM do not report portfolio weights for the
minimum variance portfolio.
It is important to recall all the limitations behind this table.
Mean variance analysis ignores skewness and kurtosis,
whereas investors may not. Investors should always consider
data-snooping biases, in the sense that small sample results
create incentives to perform studies. The number of observations is only 24 months. The result may be somewhat
misleading if the equally weighted portfolio and the S&P
500 portfolio are not mean variance efficient, although this
would be unlikely to account for the large differences in
standard deviation. Finally, AM avoided introducing the
errors in mean returns into the analysis by only examining
only the minimum variance portfolio. In the presence of a
riskless asset, an investor would be better off investing in
the tangent portfolio. The most useful evidence for the
diversification benefits of HF portfolios would be the means
and standard deviations of the tangency portfolio with and
without HFs in the optimization. (Of course, these would
suffer from the errors that AM sought to avoid.)
The difference between Mean-Variance and
Mean-VaR optimization
AM acknowledge that HF returns are not linearly related
to stock returns and that investors care about skewness and
kurtosis. They argue that a Mean-VaR efficient frontier
may better reflect these two realities. (For a given mean

return, the portfolio with the lowest VaR is on the MeanVaR efficient frontier.) However, there are reasons to be
skeptical of Mean-VaR analysis.
It implies that an investor only cares about the left tail of
the distribution, an area with probability mass of only 5%
to 1% depending on the threshold chosen. Also, it is hard
to believe that the tail of a HF return distribution can be
very precisely estimated with so few observations and even
harder to believe that covariances with other HF strategies
and traditional portfolios can be precisely estimated as
well. AM do not report the improvement of the Mean-VaR
efficient frontier due to adding HFs to a stock portfolio,
but rather limit their results to showing how, for a given portfolio, the frontier shifts from Mean-Variance to Mean-VaR
with different thresholds. Interestingly, they find relatively
small shifts.
Conclusion
For the remainder of the paper, AM apply a formal, and
rather technical, model to the case when investors have
good estimates of expected returns, in particular good estimates of the HF managers alpha. I have not covered this
material as it is less practical. I have limited focus on the
techniques and issues addressed above to illustrate the
difficulties in finding rigorous empirical support for the
most common claim in the HF industry, namely that
adding HFs to a stock and bond portfolio adds diversification
benefits. The secondary question is what the HF portfolio
weight should be.
In the absence of an appropriate asset allocation model, it
is no wonder that this is most often a qualitative decision.
For previous issues of the swissHEDGE and people & services of Harcourt Investment Consulting AG.
Roundtable Discussion 2nd Quarter 2004
Roundtable discussion
swissHEDGE regularly invites reputed hedge

funds to join a roundtable discussion in which
to share their views on a particular topic. This
time, we have invited three hedge funds to
share their insight into the needs of institutional investors.
intents and purposes, as much our client as is the underlying

investor. If we include money from these sources, then the
percentage of our client base from institutional investors
may be as much as one third.
MACKAYSHIELDS: Less than 5% of the assets in the hedge
fund are from institutional investors. The bulk of the assets
are from fund of hedge funds. Although we began marketing
the hedge fund to institutional investors, private investors
and fund of funds concurrently, the fund closed before
institutional investors were able to commit to it.
Deephaven Capital Management

Fund:
Deephaven Market Neutral Fund Ltd
AUM:
USD 2b
Representative: Jeffrey Applebaum,
Director of Client Relations
Q: Are you seeing an increase in institutional interest, and

what types of investors do you believe are attracted to
hedge funds?
Introduction
Henderson Global Investors

Fund:
Various
AUM:
USD 1.5b
Representative: Stuart MacDonald, Director of Hedge
Fund Development
MacKayShields
Fund:
MacKayShields LongShort Fund
(Offshore) LP
AUM:
USD 720m
Representative: Maureen McFarland, CFA, Director,
International Development
Q: What percentage of your assets stems from institutional

investors, and how has that changed over time?
DEEPHAVEN: 75%, which includes institutionally oriented
fund of funds. This is up from 25% five years ago.
HENDERSON: Bearing in mind that Henderson Global
Investors approx. USD1.5 b of hedge fund assets is managed in a series of single manager funds rather than multimanager offerings, the percentage received directly from
such investors is relatively small (under 10%). The proportion
is, however, increasing, especially for our multi-strategy
funds. It is in any case difficult to define this part of our
investor base precisely, since much of this money is intermediated by fund of funds or consultants who are, to all
swissHEDGE 32
DEEPHAVEN: We are seeing an increase in institutional

interest with, at the margin, an increase from corporate and
public pension funds the endowments and foundations
have been invested in hedge funds already; the investors
who are looking to invest in hedge funds are those that are
looking for absolute returns (and not relative returns), and
who are looking to diversify away from equities.
HENDERSON: Yes. There is a great deal of evidence that
institutional demand for hedge funds is increasing,
although the industry would do well to follow the old
dictum of not counting its chickens before they are hatched.
According to a recent Greenwich Associates survey of nearly
2,500 institutional investors in North America, Europe, the
UK and Japan showed that US and Canadian institutions
have about 1% of their assets in hedge funds (approx.
$42b, up from $32b in 2002); the Europeans have $ 8b (up
from $3b in 2002) and in 2003, $1b each was added to
hedge fund allocations by UK and Japanese institutions.
So, only about $17b of this money apparently came into
play last year. Whilst we maintain contact with a number of
pension schemes, insurance companies, foundations, endowments and public sector bodies (those that invest directly in
single manager funds), our main focus is on gathering assets
from those who manage institutions money for them or
those who advise them.
MACKAYSHIELDS: Since the close of the hedge fund,
we have seen significant interest in our hedge fund from
institutional investors, as well as fund of funds and private
investors.
Q: Why do you believe institutional allocations in Europe

have historically lagged the US?
Q: How do you believe the advent of institutional investors

change the dynamics of our business?
DEEPHAVEN: I am not sure that this is true-in fact, certainly on the retail side, Europe is ahead of the US investor
base in terms of investing in hedge funds but if it is true, I
would imagine it has something to do with the majority of
hedge funds being in the US and the more adventuresome
plan sponsors in the US as well.
HENDERSON: Conservatism and the domination of this
segment of the market in the past by traditionally minded
consultants whose orientation is not suited to the adoption
of non-traditional approaches.
DEEPHAVEN: In many ways the interest and demand for

hedge funds will affect the dynamics of our business. First,
hedge funds that do not have the infrastructure to be considered an institutional money manager will not be able to
attract money from large institutional investors because institutions need to invest in other institutions for risk control
purposes and client service purposes. Further, as more
money comes into the strategies that are capacity constrainedfor example, the returns of many arbitrage strategies will
have to moderate as demand will outstrip supply.
HENDERSON: So long as such investors portfolios are
well constructed, the effect should not necessarily be on the
types of strategy that companies such as ours offer. There
may, however, be a greater emphasis than ever on process
rather than flair and it needs to be recognised that an
institutional investor, driven at least in part by liability
matching considerations, will not allocate in the same way
as an individual client of a private bank who regards hedge
funds as spice.
Q: What attracts institutional investors to hedge funds,

and how are you fulfilling these needs?
DEEPHAVEN: They realize that they can lose money in
stocks and thus they want an absolute return not a relative
return. Deephaven, with our focus on multiple arbitrage
strategies, provides an absolute return investment vehicle
that is perfectly designed to meet the needs of institutions
looking to earn positive returns in any market environment
that are low risk and not correlated with equities.
HENDERSON: We have products that attract particular
interest from institutional investors and their advisors.
These are multi strategy and therefore well diversified,
with a particular emphasis on the risk management side of
the equation and the production of reasonably steady
return distributions. On the other hand, we have some
institutional investors who have invested in our somewhat
more expansive long short equity funds (Europe, Japan,
Asia Pacific and the UK) in the context of well diversified
portfolios that they operate.
MACKAYSHIELDS: Institutional investors appear to be
attracted to hedge funds for potential diversification benefits,
as well as potential return enhancement. It was our experience, however, that institutions were primarily interested
in investing in our hedge fund via fund of funds, thereby
relying on the fund of funds for due diligence and allocation
decisions among the various types of hedge funds. Although
several institutions expressed interest in investing in our
hedge fund, these institutions were unable to commit to
our fund prior to the close. It was our experience that the
funds of funds were able to complete their due diligence
and commitment processes more quickly than their institutional counterparts.
Q: Fund of funds are expected to remain the main beneficiary of institutional allocations. Do you agree? If yes,
why; if no, why?
DEEPHAVEN: I agree. Many pundits have predicted the
demise of fund of funds and that the large institutions will
go directly into funds but we do not see this happening
en masse for a number of reasons. Some of which include
that the institutional investors do not have the staff to conduct the research that is done by the funds of funds and
there is very little in the way of single manager hedge fund
research being conducted by the traditional pension fund
consultants who dominate the money flows of the institutions and who are recommending primarily fund of funds
as a way of accessing alpha from hedge funds.
HENDERSON: Yes, and I believe that investors should be
prepared to pay a premium for the services of the more
successful ones. This may, however, in future take the form
partly of funds of funds managers concentrating on providing active overlays to passive investible indices. This
will be driven not least by capacity constraints in a number
of hedge fund strategies, which may truncate the continued growth of some of the largest multimanager players
and lead to an emphasis on value added results that come
swissHEDGE 33
through focussed rather than ubiquitous coverage.

MACKAYSHIELDS: Based upon our experience, it appears
that fund of funds generally have more established procedures for analyzing hedge funds, as well as better access to
individual hedge funds given that their investable assets are
typically greater. Although some institutions are able to
gain access to premier and/or emerging hedge funds, some
of these hedge funds may view the institutions relatively
smaller investment size and more onerous servicing
requirements as less attractive investors than funds of
funds.
Q: How do you view the role of consultants in the asset
allocation process of institutions?
DEEPHAVEN: Very important. They, for the most part, are
only recommending fund of funds which will continue to
enable the fund of funds to be the main direct beneficiary
of institutional allocations but will benefit large institutional
oriented hedge funds that can accomodate the needs of the
fund of funds-client service capabilities, risk controls, operational procedures, and good money management.
HENDERSON: The small but growing number of independent consultants on either side of the Atlantic seem
often to be considerably ahead of the curve compared to
most of the traditional consulting actuaries.
Q: What do you see as the biggest risk for the hedge funds
industry?
DEEPHAVEN: The biggest risk is that the returns will
moderate for the hedge fund industry and investors and
managers will be disappointed with the results- the best
and brightest money managers are migrating to hedge
funds which will limit the opportunity set to make money.
HENDERSON: Either a blow up involving structured
products that have been sold to retail investors as hedge
fund products or a failure of the supply side to maintain
margins, thereby diluting the inflow of talent that is necessary to continue to attract the best talent into hedge funds.
Q: Do you believe the exponential industry growth is
sustainable?
DEEPHAVEN: I believe that the growth of our industry is
in its infancy-more money will flow into this area than all of
us can imagine-that being said, this may not lead to what
investors or managers want.
swissHEDGE 34
HENDERSON: To a point, yes, although some strategies

can bear more capital than others (e.g. global macro fixed
income vs. pure credit plays). This applies especially if
products such as investible indices can absorb some of the
future institutional and retail demand for hedge funds.
What may emerge is a two tier industry defined by scarce
capacity high alpha products in less scaleable strategies,
sold at a premium, with less exciting, more steady state
products absorbing a lot of the extra demand. In any case,
a return of the bull market will probably divert many
investors attention back towards traditional, long only
investing, although the progressive paradigm shift in favour
of alternative investments such as hedge funds is almost
certainly a durable one.
MACKAYSHIELDS: As investors search for innovative
products, which provide diversification benefits and ultimately higher returns, allocations to hedge fund products
and alternative assets in general are likely to continue.
There is little doubt that a maturing market will bring
changes, particularly in investor relationships with individual hedge funds. As investors knowledge and experience
with hedge funds develop, and as those hedge funds evolve
to meet investor needs, so too should the demand for
hedge funds continue to grow.
HARCOURT EVENTS 2004

Quarterly HF Presentation
May
08.30-10.00
Stockholm
11 May
08.30-10.00 / 12.15-13.45
Lugano / Milan
12 May
08.30-10.00
Geneva
13 May
08.30-10.00
Amsterdam
14 May
08.30-10.00
Zurich
19 May
12.30-14.00
Frankfurt
14 September
08.30-10.00 / 12.15-13.45
Lugano / Milan
15 September
08.30-10.00
Geneva
15 September
08.30-10.00
Stockholm
16 September
08.30-10.00
Amsterdam
17 September
08.30-10.00
Zurich
22 September
12.30-14.00
Frankfurt
08.30-10.00 / 12.15-13.45
Lugano / Milan
10 November
November
08.30-10.00
Geneva
10 November
08.30-10.00
Stockholm
11 November
08.30-10.00
Amsterdam
12 November
08.30-10.00
Zurich
17 November
12.30-14.00
Frankfurt
To register for any of Harcourt's events, please go to www.harcourt.ch.
UPCOMING CONFERENCES 2004

May
18-20, 2004
Hedge Funds World Asia

Grand Hyatt, Singapore, www.hedgefundsworld.com
May
20, 2004
Local Government Pension Investment Forum 2004

Vintners' Hall, London, United Kingdom, http://www.iir-conferences.com
May
20, 2004
4th Hedge Fund Conference organised by Borsa Italia

Teatro del Terme, Milano, Italy, www.borsaitalia.it
June
8-10, 2004
GAIM: The 10th Annual Global Alternative Investment Management Forum

Beaulieu, Lausanne, Switzerland, http://www.icbi-uk.com/gaim/
swissHEDGE 0
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2nd Quarter 2004

A Review on Developments in the Hedge Fund Market

The Impact of Institutional Investors

Quarterly Review | Dr. Philipp Cottier | Harcourt AG

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

Investors View | Michael Busack | Absolut Research GmbH

Special Feature | Alexander M. Ineichen | UBS

Academic Literature Review | Jim Brandon | BAAM GmbH

Roundtable Discussion 2 Quarter 2004

Events | Harcourt Events 2004 | Upcoming Conferences 2004

swissHEDGE | 2nd Quarter 2004

Editorial | Dr. Kurt Lambert | Harcourt AG

Is there fee pressure for funds of funds?

By: Dr. Kurt Lambert | Harcourt AG

few funds of funds managing in excess of USD1b.

Hedge fund industry commentary: first quarter 2004

By: Dr. Philipp Cottier | Harcourt AG

World, S&P 500, MSCI Europe and Topix indices returned

Hedge Fund Strategy

HFR Funds of Funds

Source: Hedge Fund Research Inc., Barclay Trading Group Ltd.

while 10-year rates decreased from 4.30% to 3.94%.

lasts. Volatility may become more tame and bi-directional.

Nickel, continued their upward move and also performed

in USD interest rates, a weakening US real estate market, plus

Graph1 | Long term performance comparison

Hedge Fund Composite Index

MSCI World Total Return Index

Source: MSCI; TASS; Hedge Fund Research Inc.

should remain only little capacity constrained, with the

multi-strategy funds. Yet others hire a whole stable of traders

The edge in hedge fund administration

with every possible advantage, to help start, manage and grow

British Virgin Islands Cayman Islands Curaao Dublin

Hong Kong London Luxembourg

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

How will institutional investors change the fund of hedge

By: Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

Here they come: institutional allocations on

A thing long expected. Alternative ways of investing

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

Graph 1 | Percentage of European institutions currently investing in hedge funds

Source: Deutsche Bank 2003

Swiss pension allocations differ markedly from, for example,

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

Graph 2 | Classification framework of hedge funds vs.

Another often cited attraction to hedge funds is that they

Graph 3 | Hedge Funds vs. MSCI World, 1990-2003

MSCI World ($)

HFRI Funds of Funds Composite Index

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

Graph 4 | Main problems cited by European institutions

Graph 5 | Primary reasons investors require additional

Source: Deutsche Bank 2003

Source: Deutsche Bank 2004

be able to manage it appropriately as allocations increase.

Replicable and transparent processes. The strength of

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

to educate investors about hedge funds. First the intellectual

strategies where informational asymmetries are high (ai,

Strategy Focus | Dr. Kurt Lambert, Marcel Herbst | Harcourt AG

that hedge funds like to diversify their investor base and

Capacity to any single