global lemmings and pioneers equity...

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GlobalEquity

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Companies mentionedand disclosures p. 31

Alexander M. Ineichen, CFA+44-20-7568 4944

[email protected]

Jens Johansen+44-20-7568 8097

[email protected]

Lemmings and Pioneers■■■■ Most market observers consider 1949 the birth date for so-called absolute return

managers, that is, the hedge fund industry. However, if we loosen the definitionof hedge funds and define hedge funds as individuals or partners pursuingabsolute return strategies by utilising traditional as well as non-traditionalinstruments and methods, leverage, and optionality, then the birth date forabsolute return strategies is much earlier than 1949.

■■■■ One could argue that in any market there are trend followers (lemmings) andpioneers, or very early adopters. The latter category is by definition a minority.The pension and endowment funds loading up exposure to hedge funds duringthe bull market of the 1990s were a minority. The majority of institutional aswell as private investors took what the press wrote about hedge funds forgranted and steered away from them. However, economic logic would suggestthat it is this pioneering minority who have captured an economic rent for therisk they took by moving away from the comfort of the consensus. As the hedgefund industry matures, becomes institutionalised and mainstream, and eventuallyconverges with the traditional asset management industry, this rent will be gone.The lemmings might not get to share the economic rent the pioneers captured.

■■■■ We use the current ‘quiet period’ for hedge funds (the 12-month volatility of theHFRI Fund of Funds Index was just 2.5%, suggesting we are in calm markets) toupdate some performance figures as well as some industry statistics.

Alternative Investment Strategies 18 October 2002

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2 UBS Warburg

Contents page

Lemmings and pioneers................................................................................. 3

— Introduction......................................................................................... 3

— Lemmings and pioneers ...................................................................... 4

— The first hedge funds........................................................................... 5

— The 1950s and 1960s.......................................................................... 6

— The 1970s ........................................................................................ 10

— The 1980s ........................................................................................ 10

— The 1990s ........................................................................................ 12

— Industry update ................................................................................. 14

— Conclusion........................................................................................ 25

— References ....................................................................................... 26

Performance update ................................................................................... 27

— The shorts go marching on ................................................................ 27


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Lemmings and pioneersIntroductionMost market observers consider 1949 the birth date for so-called absolute returnmanagers, that is, the hedge fund industry. However, if we loosen the definition ofhedge funds and define hedge funds as individuals or partners pursuing absolutereturn strategies by utilising traditional as well as non-traditional instruments andmethods, leverage, and optionality, then the birth date for absolute return strategiesis much earlier than 1949.

One early reference to a trade involving non-traditional instruments and optionalityappears in the Bible. Apparently, Joseph wished to marry Rachel, the youngestdaughter of Leban. According to Frauenfelder (1987), Leban, the father, sold a(European style call) option with a maturity of seven years on his daughter(considered the underlying asset). Joseph paid the price of the option through hisown labour. Unfortunately, at expiration Leban gave Joseph the older daughter,Lea, as wife, after which Joseph bought another option on Rachel (same maturity).Calling Joseph the first absolute manager would be a stretch. (Today absolute returnmanagers care about settlement risk.) However, the trade involved both non-traditional instruments and optionality, and risk and reward were evaluated inabsolute return space.

Gastineau (1988) quotes Aristotle’s writings as the starting point for options. Onecould argue that Aristotle told the story of the first directional macro trade: Thales,a poor philosopher of Miletus, developed a 'financial device, that involves aprinciple of universal application.' People reproved Thales, saying that his lack ofwealth was proof that philosophy was a useless occupation and of no practicalvalue. However, Thales knew what he was doing and made plans to prove to othershis wisdom and intellect. Thales had great skill in forecasting and predicted that theolive harvest would be exceptionally good the next autumn. Confident in hisprediction, he made agreements with area olive-press owners to deposit what littlemoney he had with them to guarantee him exclusive use of their olive presses whenthe harvest was ready. Thales successfully negotiated low prices because theharvest was in the future and no one knew whether the harvest would be plentiful orpathetic, and because the olive-press owners were willing to hedge against thepossibility of a poor yield. Aristotle’s story about Thales ends as one might guess:When the time came to harvest and many presses were wanted all at once, Thalessold high and made a fortune.

Thus he showed the world that philosophers can easily be rich if they like, but thattheir ambition is of another sort.1 So Thales exercised the first known options tradesome 2,500 years ago. He was not obliged to exercise the options. If the oliveharvest had not been good, Thales could have let the option contracts expire unusedand limited his loss to the original price paid for the options. However, as it turnedout, a bumper crop came in, so Thales exercised the options and sold his claims onthe olive presses at a high profit. The story is an indication that a contrarianapproach (trading against the crowd) might have some merit.

1 Note that George Soros, according to his own assessment, failed as philosopher but succeeded as an investor. FromSoros (1987).

The absolute return approachgoes further back than 1949

Absolute return strategieswere executed in biblicaltimes

Thales of Miletus was thefirst macro manager

Philosophers are probablycontrarians by definition


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Lemmings and pioneersOne could argue that in any market there are trend followers (lemmings) andpioneers, or very early adopters. The latter category is by definition a minority. Inthe early 1990s, some people were running around with mobile phones the size of ashoe. At the time the author of this article thought they were in need of professionalhelp – having a private conversation in a public place did not seem to be more thana short-term phenomenon of some whose oversized egos forced them to displaytheir importance to those surrounding them. The author therefore did not buy Nokiashares in the early 1990s and – unfortunately – cannot claim to be a pioneer or tohave superior foresight. It turned out that those egomaniacs were really thepioneers, and it is us – the lemmings – who have adopted their approaches andprocesses.

In asset management there is a similar phenomenon. The pension and endowmentfunds loading up exposure to hedge funds during the bull market of the 1990s werethe exception. They belong to a small minority of investors. The majority ofinstitutional as well as private investors took for granted what was written abouthedge funds in the press and steered away from them. However, economic logicwould suggest that it is this pioneering minority who have captured an economicrent for the risk they took by moving away from the comfort of the consensus. Asthe hedge fund industry matures, becomes institutionalised and mainstream, andeventually converges with the traditional asset management industry, this rent willbe gone. The lemmings will not share (or will share to a much smaller extent) theeconomic rent the pioneers captured.

As Humphrey Neill (2001), author of The Art of Contrary Thinking, puts it;

A common fallacy is the idea that the majority sets the pattern and thetrends of social, economic, and religious life. History reveals quite theopposite: the majority copies, or imitates, the minority and this establishesthe long-run developments and socioeconomic evolutions.

Trend following is not irrational. In a market where there is uncertainty and whereinformation is not disseminated efficiently, the cheapest strategy is to follow aleader, a market participant who seems to have an information edge. This, however,increases liquidity risk in the marketplace. Persaud (2001) discusses herd behaviourin connection with risk in the financial system and regulation. He makes the pointthat turnover is not synonymous with liquidity. Liquidity means that there is amarket when you want to buy as well as when you want to sell. For this two-waymarket, diversity, and not high turnover, is key. Shiller (1990) and others explainherding as taking comfort in large numbers, somewhat related to the IBM effect:'No one ever got sacked for buying IBM.' In the banking industry, for example,lemming-like herding is a risk to the system. If one bank makes a mistake, it goesunder. If all banks make the same mistake, the regulators will bail them out in orderto preserve the financial system.1,2 Lemming-like herding, therefore, is a rationalchoice.

1 From Persaud (2001), p 112 In a recent example of this, the UK FSA bailing out life insurance funds by first relaxing the test of resilience againstmarket downturns, then reinstating it, and then changing the methodology for calculating equity asset values.

Pioneers, as a group, are aminority by definition

Economic rents have anunfortunate tendency toevaporate

Lemming-like behaviour canbe rational


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In Warren Buffett’s opinion, the term 'institutional investor' is becoming anoxymoron: Referring to money managers as investors is, he says, like calling aperson who engages in one-night stands romantic.1 Buffett is not at par with themodern portfolio theory. He does not run mean-variance efficient portfolios. Criticsargue that, because of the standard practices of diversification, money managersbehave more conservatively than Buffett. According to Hagstrom (1994), Buffettdoes not subscribe to this point of view. He does admit that money managers investtheir money in a more conventional manner. However, he argues thatconventionality is not synonymous with conservatism; rather, conservative actionsderive from facts and reasoning.

Some argue that history has a tendency to repeat itself. The question therefore iswhether we already have witnessed such a phenomenon, such as the currentparadigm shift (to move from the relative return paradigm to the absolute returnparadigm2) in the financial industry. A point can be made that we have: in the 1940sanyone investing in equities was a pioneer. Back then there was no consensus that aconservative portfolio included equities at all. Pension fund managers loading upequity exposure were the mavericks of the time.

Some pension funds (pioneers perhaps) have moved into inflation-indexed bondportfolios and thereby matching assets with liabilities, that is, locking in any fundsurplus rescued from the bear market. What if this is a trend? What if there is alemming-like effect whereby the majority of investors take risk off the table at thesame time? If the incremental equity buyer dies or stops buying there is only oneway equity valuations will head and equity prices will go.

The first hedge fundsThe official (most often quoted) starting point of hedge funds was 1949 whenAlfred Winslow Jones opened an equity fund that was organised as a generalpartnership to provide maximum latitude and flexibility in constructing a portfolio.The fund was converted to a limited partnership in 1952. Jones took both long andshort positions in securities to increase returns while reducing net market exposureand used leverage to further enhance the performance. Today the term 'hedge fund'takes on a much broader context, as different funds are exposed to different kinds ofrisks.

Other incentive-based partnerships were set up in the mid-1950s, including WarrenBuffett’s Omaha-based Buffett Partners and Walter Schloss’s WJS Partners, buttheir funds were styled with a long bias in the manner of Benjamin Graham’spartnership (Graham-Newman). Under today’s broadened definition, these fundswould also be considered hedge funds, but regularly shorting shares to hedgemarket risk was not central to their investment strategies.3

Jones merged two investment tools – short selling and leverage. Short selling wasemployed to take advantage of opportunities of stocks trading too expensivelyrelative to fair value. Jones used leverage to obtain profits, but employed short

1 From Hagstrom (1994), p 732 See UBS Warburg ‘The Search for Alpha Continues’ (2001) or Ineichen (2002)3 From Caldwell and Kirkpatrick (1995)

Many investors, potentially,confuse conventionalismwith conservatism

The long-only equity cult is asign of modern times

Alfred W. Jones is credit withfounding the first hedge fund

Jones’s use of short sellingand leverage is still largelymisunderstood


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selling through baskets of stocks to control risk. Jones’ model was devised on thepremise that performance depends more on stock selection than market direction.He believed that during a rising market, good stock selection will identify stocksthat rise more than the market, while good short stock selection will identify stocksthat rise less than the market. However, in a declining market, good long selectionswill fall less than the market, and good short stock selection will fall more than themarket. The fund was thus designed to yield a net profit in all markets. To thoseinvestors who regarded short selling with suspicion, Jones would simply say that hewas using ‘speculative techniques for conservative ends.’1

Jones kept all of his own money in the fund, realising early that he could not expecthis investors to take risks with their money that he would not be willing to assumewith his own capital. Caldwell (1995) points out that the motivational dynamics ofAlfred Jones’ original hedge fund model runs straight to the core of capitalisticinstinct in managers and investors. The critical motives for a manager are highincentives for superior performance, coupled with significant personal risk of loss.The balance between risk seeking and risk hedging is elementary in the hedge fundindustry today. A manager who has nothing to lose has a strong incentive to 'riskthe bank.'

The 1950s and 1960sIn April 1966, Carol Loomis wrote the aforementioned article called 'The JonesNobody Keeps Up With'. Published in Fortune, Loomis’ article shocked theinvestment community by describing something called a 'hedge fund' run by anunknown sociologist named Alfred Jones.2 Jones’ fund was outperforming the bestmutual funds even after a 20 percent incentive fee. The news of Jones’ performancecreated excitement, and by 1968, approximately 200 hedge funds were in existence.

During the 1960s bull market, many of the new hedge fund managers found thatselling short impaired absolute performance, while leveraging the long positions,created exceptional returns. The so-called hedgers were, in fact, long, leveraged andtotally exposed as they went into the bear market of the early 1970s. During thistime many of the new hedge fund managers were put out of business. Fewmanagers have the ability to short the market, since most equity managers have along-only mentality.

Caldwell (1995) argues that the combination of incentive fees and leverage in a bullmarket seduced most of the new hedge fund managers into using high margin withlittle hedging, if any at all. These unhedged managers were ‘swimming naked.’3

Between 1968 and 1974 there were two downturns, 1969–1970 and 1973–1974.The first was more damaging to the young hedge fund industry, because most of thenew managers were swimming naked (ie, were unhedged). For the 28 largest hedgefunds in the Securities and Exchange Commission (SEC) survey at year-end 1968,assets under management declined 70 percent (from losses as well as withdrawals)

1 From Caldwell and Kirkpatrick (1995)2 From Caldwell (1995), p. 9.3 Caldwell (1995), p. 10.

Balancing risk seeking andrisk aversion is only possibleif the manager has somethingto lose

Superior performance hasalways attracted capital

Long-only mentality resultsin long bias

The hedge funds’ industryArmageddon was in the1970s


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by year-end 1970, and five of them were shut down.1 From the spring of 1966through to the end of 1974, the hedge fund industry ballooned and burst, but anumber of well-managed funds survived and quietly carried on. Among themanagers who endured were Alfred Jones, George Soros, and Michael Steinhardt.2

Hedge funds – the Warren Buffett wayA potentially interesting aspect about the hedge funds industry is the involvementof Warren Buffett, which is not very well documented as Buffett is primarilyassociated with bottom-up company evaluation and great stock selection. He isoften referred to as the best investor ever and an antithesis to the efficient markethypothesis (EMH). According to Hagstrom (1994), Warren Buffett started apartnership in 1956 with seven limited partners. The limited partners contributedUS$105,000 to the partnership. Buffett, then 25 years old, was the general partnerand, apparently, started with US$100. The fee structure was such that Buffettearned 25 percent of the profits above a six percent hurdle rate, whereas the limitedpartners received six percent annually plus 75% on the profits above the hurdle rate.Between 1956 and 1969, Buffett compounded money at an annual rate of 29.5percent despite the market falling in five out of 13 years. The fee arrangement andfocus on absolute returns even when the stock market falls look very much likewhat absolute return managers set as their objective today. There are moresimilarities:

■■■■ Buffett mentioned early on that his approach was the contrarian/value-investorapproach and that the preservation of principal is one of the major goals of thepartnership.3 Today, capital preservation is one of the main investment goals ofall hedge fund managers who often have a large portion of their own net wealthalongside that of their investors. Warren Buffett’s partnership had a long biasafter Benjamin Graham’s partnership. Selling short was not central to theinvestment strategy.

■■■■ Buffett’s stellar performance attracted new money. More partnerships werefounded. In 1962 Buffett consolidated all partnerships into a single partnership(and moved the partnership office to Kiewit Plaza in Omaha, Nebraska). Thefact that stellar performance attracts capital is not new. Superior performanceattracts capital in retail mutual funds as well as hedge funds.

■■■■ As the Nifty Fifty stocks like Avon, IBM, Polaroid, and Xerox were trading at50 to 100 times earnings, Buffett had difficulties finding value. He ended hispartnership in 1969. Buffett mailed a letter to his partners confessing that he wasout of step with the current market environment:

'On one point, however, I am clear. I will not abandon a previous approachwhose logic I understand, although I find it difficult to apply, even though it maymean foregoing large and apparently easy profits to embrace an approach

1 Normally the argument goes that the mutual fund industry is in a mature stage of its life cycle, while hedge funds are inan early stage. However, one, potentially, could argue that it is the other way around. Hedge funds had their Armageddonin the 1970s. The long-only industry is having it now.2 Caldwell (1995), p. 11.3 From Hagstrom (1994), p. 3.


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which I don’t fully understand, have not practiced successfully and whichpossibly could lead to substantial permanent loss of capital.”1

These notions sound like an absolute return investment philosophy. There are twoanecdotes with this notion: first, in recent years some market observers wereclaiming that Warren Buffett finally 'lost it' as he refused to invest in the technologystocks of the 1990s, just as he had refused to invest in the Nifty Fifty stocks threedecades earlier. The lesson to be learned is that absolute return managers do not pay100 times prospective earnings, whereas relative return managers do.2 WarrenBuffett’s quotation looks very similar to quotes by Julian Robertson, who wrote toinvestors in March 2000 to announce the closure of the Tiger funds (after losses andwithdrawals). Robertson was returning money to investors, as did Warren Buffett in1969. Robertson said that since August 1999, investors had withdrawnUS$7.7 billion in funds. He blamed the irrational market for Tiger's poorperformance, declaring that 'earnings and price considerations take a back seat tomouse clicks and momentum.'3 Robertson described the strength of technologystocks as 'a Ponzi pyramid destined for collapse.' Robertson’s spokesman said thathe did not feel capable of figuring out investment in technology stocks and nolonger wanted the burden of investing other people’s money.

These notions of throwing in the towel (returning money or moving into cash) dueto a lack of opportunities touches on a debate currently unfolding in the hedge fundindustry. Some argue that an investors should not pay 1+20 to the manager forholding cash. We, on the other hand, argue they should. Our argument is based onthe two beliefs that cash is the ultimate instrument to control downside risk and thatthe investor pays the manager to manage absolute risk, that is, preserve principal indifficult times. In other words, the mandate of the manager includes judgingwhether the opportunity set in his field of expertise is rich or poor. This judgmentalcall is subjective by definition and therefore not passively replicable (hence, thejustification for an active fee). The deleveraging and move into cash by long/shortmanagers is a good example of this judgmental call. They did not make a lot ofmoney (as a group) in the most recent past, but at least they did not lose a lot.

The result of this risk aversion on the downside is superior performance over thefull cycle and capital preservation under difficult market conditions. Comparing theHFRI Equity Hedge Index with the MSCI World Index (a proxy for long-onlymoney management) illustrates this point of view: the two indices rose by 750.3percent (18.3 percent annualised) and 68 percent (4.2 percent per annum) fromJanuary 1990 to September 2002. From January 2000 to September 2002, thelong/short equity index rose by 1.1 percent while the MSCI World went the otherway by 45.7 percent. This, we believe, is not only a bid difference, but alsomanifests the notion that risk management should be active and focus on absolutereturns. In other words, change requires action, while hugging the status quo (or themarket index) does not, and might be considered unwise. Or as Keynes put it:'When circumstances change, I change my view. What do you do?'

1 From Hagstrom (1994), p 4 quoting from Train (1981), p 112 Assuming the stock is in the benchmark portfolio and the marginal contribution to active risk is not negligible.3 Letter from Tiger Management LLC to limited partners dated 30 March 2000.

Mouse clicks and momentum

Active risk managementresults in asymmetricreturns…

… which should, ideally, leadto superior long-termperformance


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There are some similarities between Buffett and Soros: Both Warren Buffett andGeorge Soros are contrarians.1 There is a possibility that successful investors arecontrarians by definition. Hagstrom (1994) quotes Buffett: 'We simply attempt to befearful when others are greedy and to be greedy only when others are fearful.'2 Thissounds (in terms of content, not phraseology) very much like what George Soroshas to say: 'I had very low regard for the sagacity of professional investors and themore influential their position the less I considered them capable of making theright decisions. My partner and I took a malicious pleasure in making money byselling short stocks that were institutional favourites.'3 Buffett compares investingwith a game: 'As far as I am concerned the stock market doesn’t exist. It is thereonly as a reference to see if anybody is offering to do anything foolish. It’s likepoker. If you have been in the game for a while and don’t know who the patsy is,you’re the patsy.' There are some similarities with how George Soros seesinvesting: 'I did not play the financial markets according to a particular set of rules;I was always more interested in understanding the changes that occur in the rules ofthe game.'4

Shareholders of Berkshire Hathaway were also exposed to various forms ofarbitrage, namely risk arbitrage and fixed income arbitrage. Over the past decades,Warren Buffett created the image of being a grandfatherly, down-to-earth, long-term, long-only investor, repeatedly saying he invested only in opportunities heunderstood and implying a lack of sophistication for more complex tradingstrategies and financial instruments. However, there is no lack of sophistication atall. According to Hagstrom (1994) Buffett was involved in risk arbitrage (akamerger arbitrage) in the early 1980s and left the scene in 1989 when the gamebecame crowded and the arbitrage landscape was changing. In 1987, BerkshireHathaway invested in US$700 million of newly issued convertible preferred stocksof Salomon Inc. Salomon was the most sophisticated and most profitable fixedincome trading house of the time and the world’s largest fixed income arbitrageoperation. Long Term Capital Management (LTCM) was founded and built on theremains of Salomon staff after the 1991 bond scandal.5 Warren Buffett becameinterim chairman of Salomon after chairman John Gutfreund resigned. Hagstrom(1994) argues that 'Buffett’s presence and leadership during the investigationprevented Salomon from collapsing.' Had the board, led by Warren Buffett, notpersuaded US attorneys that it was prepared to take draconian steps to make things

1 Many investors believe they are contrarians – which, by definition, is not possible. Contrarian principles are nothing new.Jean-Jacques Rousseau was quoted saying: ‘Follow the course opposite to custom and you will almost always do well.’Note that the introduction of a benchmark index is, to some extent, the opposite of the contrarian approach as stocks andsectors that have outperformed have become larger in terms of portfolio weight.2 One could argue that a relative return manager can execute a contrarian approach as well. However, there is a strongincentive not to, since many investors evaluate managers on a yearly (or maximum three-year) basis. This means that notparticipating in a bubble, which can take many years to unfold and then burst, is too risky. The relative return manager willbe pushed out of business before he or she is proven right. This is one of the odd incentives that absolute returnmanagers want to avoid from the start.3 Soros (1987), p 15.4 Soros (1987), p.15.5 In August 1991, Salomon controlled 95 percent of the two-year treasury notes market despite rules only permitting 35percent of the total offering. Salomon had exceeded this limit by a wide margin and admitted to violating treasury actionrules. From Hagstrom (1994), p 171.

Long-term successfulinvestors, potentially, arecontrarians by definition

Buffett was an early investorin fixed income arbitrage


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right, it seems highly likely that the firm would have been indicted and followedDrexel Burnham to investment banking’s burial ground.1

Warren Buffett’s Berkshire Hathaway was invested in Bermuda-based West EndCapital during the turbulence caused by the Russian default crisis in 1998.Berkshire contributed 90 percent of the capital raised in July 1998 to West EndCapital, which attempts to profit through bond convergence investing and uses lessleverage (around 10 to 15 times) than comparable boutiques. However, theinvestment is not sizable when compared to long-only positions. In August 1998,John Meriwether approached Buffett about investing in LTCM. Buffett declined.2

Later Buffett offered to bail out LTCM, an offer that was ultimately declined byLTCM.3

Throughout his extremely successful career, Warren Buffett has had some kind ofinvolvement in what today is called the hedge fund industry, that is, moneymanagers seeking absolute returns for their partners and themselves whilecontrolling unwanted risk.

The 1970sElden (2001) estimates that by 1971 there were no more than 30 hedge funds inexistence, the largest having US$50 million under management. The aggregatecapital of all hedge funds combined was probably less than US$300 million.

In the years following the 1974 market bottom, hedge funds returned to operating inrelative obscurity, as they had prior to 1966. The investment community largelyforgot about them. Hedge funds of the 1970s were different from the institutions oftoday. They were small and lean. Typically, each fund consisted of two or threegeneral partners, a secretary, and no analysts or back-office staff.4 The maincharacteristic was that every hedge fund specialised in one strategy (this, too, isdifferent from today). Most managers focused on the Alfred Jones model,long/short equity. As hedge funds represented such a small part of the assetmanagement industry, they went unnoticed. This resulted in relatively littlecompetition for investment opportunities and exploitable market inefficiencies.

The 1980sOnly a modest number of hedge funds were established during the 1980s. Most ofthese funds had raised assets to manage on a word-of-mouth basis from wealthyindividuals. Julian Robertson’s Jaguar fund, George Soros’ Quantum Fund, JackNash from Odyssey, and Michael Steinhardt Partners were compounding at 40percent levels. Not only were they outperforming in bull markets, but theyoutperformed in bear markets as well. In 1990, for example, Quantum was up 30percent and Jaguar was up 20 percent, while the S&P 500 was down 3 percent andthe MSCI World Index was down 16 percent. The press began to write articles and

1 From Smith and Walter (1997), p 10.2 Bloomberg News (1998)3 Warren Buffett is the ultimate value investor, in our view. Acquiring LTCM’s positions at a discount would have been agreat trade, since most positions turned profitable after the ‘100-year flood' had settled.4 From Elden (2001), p 48.

Contrarian investors tryacquiring assets at adiscount

The less crowded a marketplace, the merrier theinefficiencies


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profiles drawing attention to these remarkable funds and their extraordinarymanagers.

Chart 1 shows an estimate of the number of hedge funds in existence through the1980s. Duplicate share classes, funds of funds, managed futures, and currencyspeculators were not included in the graph.

Chart 1: Hedge fund growth in the 1980s

0

50

100

150

200

250

1982 1983 1984 1985 1986 1987 1988 1989

Num

ber o

f hed

ge fu

nds

Source: Quellos Group

During the 1980s, most of the hedge fund managers in the United States were notregistered with the SEC; because of this, they were prohibited from advertising, andinstead relied on word-of-mouth references to grow their assets (Table 1). Themajority of funds were organised as limited partnerships, allowing only 99investors. The hedge fund managers, therefore, required high minimuminvestments. European investors were quick to see the advantages of this new breedof managers, which fuelled the development of the more tax-efficient offshorefunds.

Table 1: Hedge fund assets under management in the 1980s

($m) 1980 1985 1990

Global 193 517 1,288

Macro 0 0 4,700

Market-neutral 0 78 638

Event-driven 0 29 379

Sector 0 0 2

Short sales 0 0 187

Long only 0 0 0

Fund of funds 0 190 1,339

Total (excl. FoF) 193 624 7,194

Total (incl. FoF) 193 814 8,533

Source: Eichengreen and Mathieson (1998) based on MAR/Hedge dataNumbers in Table 1 are a selection from Table 2.2. in Eichengreen and Mathieson (1998), p 8.


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Caldwell (1995) puts the date where hedge funds re-entered the investmentcommunity at May 1986, when Institutional Investor ran a story about JulianRobertson.1 The article, by Julie Rohrer, reported that Robertson’s Tiger Fund hadbeen compounding at 43 percent during its first six years, net of expenses andincentive fees. This compared to 18.7 percent for the S&P 500 during the sameperiod. The article established Robertson as an investor, not a trader, and said thathe always hedged his portfolio with short sales. One of the successful trades thearticle mentioned was a bet on a falling US dollar against other major currencies in1985. Robertson had bought an option, limiting downside risk by putting only afraction of the fund’s capital at risk.2 Rohrer showed the difference between a well-managed hedge fund and traditional equity management.

The 1990sDuring the 1990s, the flight of money managers from large institutions accelerated,with a resulting surge in the number of hedge funds. Their operations were fundedprimarily by the new wealth that had been created by the unprecedented bull run inthe equity markets. The managers’ objectives were not purely financial, manyestablished their own businesses for lifestyle and control reasons. Almost all hedgefund managers invested a substantial portion of their own net worth in the fundalongside their investors.

Chart 2: Asset allocation

0%10%20%30%40%50%60%70%80%90%

100%

1990 2001

Allo

catio

n (%

)

Macro Relative value Event-driven Long/short equity

Source: Hedge Fund Research

One of the characteristics of the 1990s was that the hedge fund industry becameextremely heterogeneous. In 1990, two-thirds of hedge fund managers were macromanagers, that is, absolute return managers with a rather loose mandate.Throughout the decade, more strategies became available for investors to invest in.Some of the strategies were new; most of them were not. By the end of 2001, morethan 50 percent of the assets under management were somehow related to a variantof the Jones model, long/short equity (Chart 2). However, even the subgroup oflong/short equity became heterogeneous.

1 Rohrer (1986)2 In UBS Warburg ‘Managing the Curve’ (2002a) we make the point that long the call (plus money market) is lessspeculative as long outright, as exposure to the left hand side of the return distribution is largely eliminated.

Using leveraged investmentvehicles for conservativemeans

The move from employee toentrepreneur for life stylereasons

The industry becomesheterogeneous


13 UBS Warburg

Chart 3 compares some alternative investment strategies with the traditional long-only strategy with respect to the variation in net market exposure. The vertical linesshow rough approximations of the ranges in which the different managers areexpected to operate. The bold line indicates the range of net exposure, while thethin line shows gross exposures on both sides. The graph highlights one importantaspect of hedge fund investing: not all equity absolute return managers have thesame investment approach. This diversity results in low correlation among differentmanagers, despite the managers trading the same asset class. Low correlationamong portfolio constituents then allows construction of low-risk portfolios.

Chart 3: Different strategies of managing equity risk

-250-200

-150

-100

-50

0

50

100

150

200

250

Traditionallong-only

Opportunisticlong/short

Longbiased

Conservativelong/short

Marketneutral

Shortbiased

Mark

et ex

posu

re (%

)

Source: UBS Warburg

The 1990s saw another interesting phenomenon. A number of the establishedmoney managers stopped accepting new money to manage. Some even returnedmoney to their investors. Limiting assets in many investment styles is one of themost basic tenets of hedge fund investing if the performance expectations are goingto continue to be met. This reflects the fact that managers make much more moneyfrom performance fees and investment income than they do from management fees.Due to increasing investor demand in the 1990s, many funds established higherminimum investment levels and set long lock-up periods.

Both Julian Robertson’s Tiger Management and George Soros’ Soros FundManagement reached US$22 billion in assets in 1998, setting a record for fundsunder management.1 Both organisations subsequently shrunk in size, and Tigerultimately was liquidated. Today, there are dozens of organisations managing morethan US$1 billion.

1 From Elden (2001), p 49.

Heterogeneity leads to lowcorrelation…

… which itself results in theopportunity to construct lowvolatility portfolios

Absolute return managerscontrol growth


14 UBS Warburg

Industry updateIndustry size and growthThe hedge fund industry is still in its infancy; it is still a niche industry. Estimatesof the size of the hedge fund industry are scarce and fluctuate substantially. Theestimates for the number of funds range between 2,500 and 7,000, and assets undermanagement between US$500 billion and US$600 billion globally. Compared withglobal pension funds or US financial institutions, the estimated US$500-600 billionin assets under management remains relatively small. Global pension fund assetsgrew from US$4.6 trillion in 1990, to US$15.9 trillion in 1999.1 (At the same timethe equity holdings of pension funds increased from US$1.6 trillion toUS$8.0 trillion – or from 35 percent to 51 percent of total assets). At the end of thethird quarter of 2001, US commercial banks had US$4.9 trillion in total assets,mutual funds had assets of approximately US$3.7 trillion (compared toUS$4.9 trillion a year and a half earlier), private pension funds had US$4.0 trillion,state and local government employee retirement funds had US$2.1 trillion, and lifeinsurance companies had assets of US$3.1 trillion.2

Chart 4: Estimated size and growth of hedge fund assets

0

100

200

300

400

500

600

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Asse

ts ($

billio

n)

-40

-20

0

20

40

60

80

Annu

al gr

owth

rate

(%)

Assets under management Annual growth rate (rhs)

Source: Hedge Fund Research

Chart 4 shows an estimate of industry growth and size. Based on data from HedgeFund Research, Inc., the assets under management grew from US$38.9 billion in1990, to US$536.9 billion at the end of 2001.3 The average annual growth rate was29.3 percent, and the compounded annual growth rate was 26.9 percent. The year1997 saw accelerated growth. These funds went to a large extent into fixed incomearbitrage. Annual growth for 2000 and 2001 was 6.8 percent and 10.1 percent,respectively. The main beneficiaries were risk arbitrage (in 2000), convertible

1 Financial Times (2002)2 From Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States, 7 December2001.3 Hennessee Group LLC estimates 2001 net inflow at $144 billion and total assets under management at $563 billion atyear-end 2001. From Bloomberg News (2002).

Still a niche industry


15 UBS Warburg

arbitrage, and long/short equity. These two growth rates compare with returns forthe HFRI Hedge Fund Composite Index of 5.0 percent and 4.8 percent,respectively. In other words, asset growth was partially due to performance andpartially due to funds inflow.

Based on estimates from Hedge Fund Research, Inc, there were around 4,191 hedgefunds in operation as of the third quarter of 2001. The average annual growth ratewas 19.7 percent. The annual growth rate has been falling throughout the 1990s. Tosome extent this falling growth rate would be expected as the industry matures.However, intuitively one would not have thought that the growth rate would declineto 8.2 percent by 2001, since the barriers to entry have vanished, giving an incentiveto start a hedge fund. The attrition rate is high and that there could be measurementproblems with respect to the number of funds in the industry. Table 2 showsanother estimate for industry size and growth.

Table 2: Estimated size and growth of hedge funds industry

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Global hedge funds

No of funds 1,373 1,648 1,977 2,373 2,848 3,417 4,100 4,700 5,100 5,500 5,830 6,200 6,500 7,000

AuM (US$ m) 42 58 67 94 120 172 189 217 261 295 311 480 520 600

US hedge funds

No of funds na na na na na na na na na na na 4,150 4,250 4,400

AuM (US$ m) na na na na na na na na na na na 255 280 315

Offshore hedge funds

No of funds na na na na na na na na na na na 2,050 2,250 2,600

AuM (US$ m) na na na na na na na na na na na 225 240 285

Source: Van Hedge Fund Advisors

While flows into hedge funds are growing (albeit at a slower rate) and the equitymarket is in free fall, the funds under management relative to the marketcapitalisation of equities, for what it is worth, is increasing. Chart 5 shows theestimates from Table 2 in relation to global market capitalisation of equities basedon Datastream’s total market index. At the end of third quarter 2002, the globalequity market capitalisation was US$18.8 trillion, down from US$23.9 trillion atthe end of 2001, and from US$31.6 trillion in first quarter 2000. In other words,long-only equity strategies destroyed US$12.8 trillion from first quarter 2000 tothird quarter 2002.1 This loss figure could be an indication that we, the financialcommunity, have not yet reached the pinnacle of investment wisdom. Pioneers ininvestment management have been trying to control this kind of volatility all along.We think this could become a (prudent as well as potentially financially rewarding)trend for lemmings to follow.

1 This year's Nobel prize for economics went to Daniel Kahneman. He, together with the late Amos Tversky, came up withthe prospect theory that (in essence) suggests that losses weigh stronger than profits (disutility from losses are larger thanthe utility from profits of the same amount) and that the status quo (current level of wealth) matters. See UBS Warburg‘Asymmetric returns’ (2002b).

Investment managers whocontrol portfolio volatility andexercise an extreme aversionto absolute losses may notbe a short-term phenomenon


16 UBS Warburg

Chart 5: Hedge fund assets as percentage of equity market capitalisation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

19881989 199019911992 199319941995 199619971998 19992000 2001 Q32002

AuM

as a

perc

enta

ge o

f equ

ity m

arke

t cap

(%)

0

5

10

15

20

25

30

35

Mark

et ca

p (U

S$ tr

illion

)

Global equity market capitalisationHedge funds as percentage of global equity market capitalisation

Source: Van Hedge Fund Advisers, DatastreamAssuming AuM of US$600 billion as of Q3 02


17 UBS Warburg

Performance and risk managementThe main industry characteristic is performance, that is, risk-adjusted returns where'risk' is defined in absolute terms. Chart 6 shows an update of the annual risk/returncombinations of a selection of hedge fund strategies compared with four equityindices and a global bond index. The light blue dots mark the risk/returncombinations from January 1990 to March 2000, while the dark blue dots measurethe performance from January 1990 to September 2002. The observation period forour analysis in UBS Warburg ‘In Search of Alpha’ (2000) was from January 1990to March 2000.

Chart 6: Annual return versus volatility (1990 – Q1 00 and 1990 – Q3 02)

0

5

10

15

20

25

0 5 10 15 20Historical volatility (%)

Hist

orica

l ret

urn

(%)

Q3 2002Q1 2000

S&P 500

MSCI EuropeMSCI World

Equity Hedge

Macro

EquityMarketNeutral

JPMGlobal Bonds

Fund of Funds

Source: Hedge Fund Research, Datastream, UBS Warburg (2000)Based on annualised total returns in US dollars. 'Q3 2002' shows annual return and volatility for the period from January1990 to September 2002 while “Q1 2000” shows annual return and volatility for period from January 1990 to March 2000.

■■■■ As of March 2000, the outperformance of the HFRI Equity Hedge Index relativeto the S&P 500 was 'only' 6.5 percentage points per year, whereas theoutperformance as of third quarter 2002 was 9.1 percentage points per year. Thisis a big difference. Only a bear market reveals who has been managing riskskilfully and who has not, or as Warren Buffett puts it: 'It’s only when the tidegoes out that you see who has been swimming with their trunks off.'

■■■■ The HFRI Fund of Funds Index had underperformed the S&P 500 Index by 4.8percentage points per year as of March 2000 (13.2 percent annual return versus18.0 percent for the S&P 500). However, as of September 2002 the (dull) fundof funds industry had outperformed the S&P 500 by 1.3 percentage points peryear (10.5 percent versus 9.2 percent for the S&P 500), with a fraction of itsvolatility (5.9 percent for funds of funds, 15.1 percent for the S&P 500). Theoutperformance of fund of funds relative to the MSCI World was 1.4 percentagepoints per year (13.2 percent versus 11.8 percent) as of March 2000 and 6.3percentage points per year as of September 2002 (10.5 percent versus 4.2percent). In retrospect, we think the double fee structure was worth paying.

■■■■ Macro went from 20.2 percent annual return and 9.1 percent volatility in March2000, to 17.3 percent annual return and 8.7 percent volatility as of September

The bear market caused alllong-term average returns tofall


18 UBS Warburg

2002.1 Had US$1,000 been put into a long-only vehicle tracking the MSCIWorld in January 1990, the initial investment would have grown to US$1,680(assuming reinvestment of dividends) with high and low being US$3,129 (as ofMarch 2000) and US$760 (September 1990). Had US$1,000 been put to workwith 'speculative' macro managers, the terminal investment would have beenaround US$7,618 with high and low being US$7,618 (as of September 2002)and US$988 (as of January 1990). The consensus view is that macro managersspeculate, while long-only managers do not. This view might need revisiting.

Chart 7 compares a long-only investment in the MSCI World (which is consideredas conservative by the investment establishment and press) and the HFRI MacroIndex (which is considered as speculative by the majority of the financialcommunity).

Chart 7: MSCI World versus HFRI Macro

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Inde

x (1.1

.1990

= 10

00)

MSCI World HFRI Macro

4.2 p.a.

17.3 p.a.CARR =

Source: Hedge Fund Research, Datastream

Chart 8 shows the under water perspective for the two indices. The ultimate goal ofrisk management is to preserve wealth or principal from financial losses. If onedoes not care about losses, one does not need risk management. A passive strategywith symmetric returns would be suitable. The name of the game in riskmanagement, in our view, is achieving asymmetric returns2, that is, expandingcapital base when times are good and not losing all proceeds (and more) whencircumstances change. A 50 percent gain followed by a 50 percent loss results in anet loss of 25 percent (from 100 to 150 to 75). A loss of 50 percent followed by arebound of 50 percent results in a terminal value of 75 (from 100 to 50 to 75).

Chart 8 reveals many things. One of the less obvious is that apparently not allinvestors are equally familiar with the concept of volatility. During our analysis ofthe hedge funds industry during 2000 for UBS Warburg In Search of Alpha (2000)

1 An index with macro managers immunises single manager risk. The volatilities of some macro managers is bound to behigh, in our view. However, the low correlation among macro managers allows constructing low-volatility portfolios.2 See UBS Warburg's Asymmetric returns (2002b).

Ultimate goal of riskmanagement is to protectprincipal


19 UBS Warburg

we used data from January 1990 through to March 2000.1 Investors familiar withvolatility know that the chances of losing a lot of money with a vehicle with avolatility of 15 percent is a lot higher than with a vehicle with a volatility of 5percent.2 In 2000 this was difficult to demonstrate visually, however, today theconcept of volatility has become more illustrative. Chart 8 says it all in our view.

Chart 8: Under water perspective

0

10

20

30

40

50

60

70

80

90

100

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Inde

x as p

erce

ntag

e of a

ll-tim

e hig

h (%

)

MSCI World HFRI Macro

46.3% under water10.7% under water


Although macro managers are considered the most speculative, a portfolio of macromanagers where idiosyncratic risk has been diversified had its worst drawdown in1994, where the HFRI Macro Index was under water by around 10.7 percent. Thiscompares with 46.3 percent for the MSCI World or 65.7 percent for the DAX, inother words, a high volatility of financial instruments indicates that, potentially, itcan go down by a lot. Absolute return managers try to manage the probability oflosing large amounts of principal, that is, in derivatives jargon, they 'manage thecurve.'

Chart 9 compares the symmetric dispersion of returns of traditional long-onlyequity indices with asymmetric returns profiles from hedge fund space. The verticallines measure a rolling 12-month total return. The bold part of the vertical linemeasures 90 percent of all observations from December 1990 to September 2002.The wide horizontal tick measures the rolling 12-month return as of September2002, while the small tick measures the mean of the rolling 12-month return since1990.

1 With hindsight we know today that March 2000 was the peak for most indices.2 That’s why a five-year at-the-money put option with a volatility of 15 percent costs around 10.2 percent of spot while at 5percent volatility it only costs 2.2 percent of spot.

Drawdowns of diversifiedportfolios of macro managerssmall when compared withequity long-only exposure


20 UBS Warburg

Chart 9: Symmetric versus asymmetric returns

-40

-20

0

20

40

60

S&P 500

MSCI World

MSCI EAFE

MSCI Euro

pe

JPM Glob

al Bond

sCB Arbit

rage

FI Arbit

rage

Eq. Mark

et Neut

ralRisk

Arbitrag

eDistr

essed

Sec.Macr

oEqui

ty Hedg

eFu

nd of F

unds

12-m

onth

tota

l ret

urn

(%) Current

12-monthreturn

Mean12-monthreturn

Traditional Alternative

MeanCurrent

90%range

High

Low

Source: Hedge Fund Research, Datastream, UBS WarburgBased index data from January 1990 to September 2002.

Chart 9 shows where the superior performance is derived – from avoiding largelosses. It could be argued that the end investor wants returns that are elastic on theupside, but less elastic or inelastic on the downside. Chart 9 shows that one can losemoney with hedge funds even when single-manager risk is properly diversified. Forexample, the two indices HFRI Merger Arbitrage and HFRI Equity Hedge wereboth under water at the end of September 2002. However, what is relevant to theinvestor is the magnitude of the loss compared to the previous gain. The twomentioned hedge fund indices are under water by 1.0 percent and 2.2 percentrespectively. This is peanutswhen compared to equity indices.

Chart 10: Fund of funds performance under difficult market conditions

6.2

-3.3

1.0

-11.6

-3.7-1.8 -1.6

-13.8

-3.8 -3.8-1.6

-13.1-14.7 -15.0

-20

-15

-10

-5

0

5

10

Gulfwar

8-10.90

US raterise

1-3.1994

Asiancrisis

8-10.1997

Russiancrisis

8-10.1998

NASDAQfall

9-11.2000

WTCattack

7-9.2001

Accountingscandal5-7.2002

Thre

e-m

onth

tota

l ret

urn

(%)

HFRI Fund of Funds S&P 500


Asymmetric returns meanshigher elasticity of the upsidewhen compared with thedownside


21 UBS Warburg

Chart 10 shows the magnitude of losses of a basket of funds managers in seven ofthe most difficult market conditions for equities over the past twelve and a halfyears. In only two out of the seven occurrences did fund of funds preserve wealth.However, even if the correlation is positive in these periods, the magnitude of thelosses are more often than not a fraction of the losses of a long-only equityexposure. In other words, correlation might be positive on the downside, but theelasticity is low, that is, the magnitude of the loss is much less than unhedgedexposure to the asset class.

Chart 11 shows the 10 worst calendar quarters of the MSCI World Index comparedwith the corresponding return of the HFRI Equity Hedge and HFRI Fund of Fundsindices. Two of the 10 worst quarters occurred this year (so far). Six out of the 10most negative quarters occurred in the current bear market.

Chart 11: Ten worst quarters of the MSCI World Index (Q1 90-Q3 02)

-18.3 -18.1

-14.3 -14.2-12.8

-11.9

-9.0-8.0

-6.1-5.0

-6.1

1.7

-5.9

5.1

-2.1

-5.4

-2.7

5.2

-3.3

2.6

-1.0

7.7

-1.8

3.5

0.7

-10.0

0.5

3.3

-1.2

0.6

-20

-15

-10

-5

0

5

10

Q32002

Q31990

Q32001

Q11990

Q12001

Q31998

Q22002

Q11992

Q42000

Q32000

Quar

terly

tota

l ret

urn

(%) MSCI

WorldIndex

HFRIEquityHedge

HFRIFund ofFunds


Chart 11 allows us to compare the performance of the long/short subcategory withthe performance of fund of funds in difficult market conditions:

■■■■ Fund of funds always performed better in difficult equity market conditionsexcept in Q3 98.

■■■■ Equity long/short managers destroyed more wealth than fund of funds and lesswealth than long-only managers in these 10 quarters.

■■■■ Chart 11 suggests the negative returns are more elastic with long/short exposurethan with fund of funds exposure. However, in comparing Chart 11 with Chart9, the latter shows that elasticity of long/short is indeed higher on the downside(losses are generally larger), but the elasticity on the upside is even higher. Thismore extreme asymmetry results in the mean return being much higher for theHFRI Equity Hedge Index than for the HFRI Fund of Funds Index.


22 UBS Warburg

Industry breakdown by sizeChart 12 shows estimates for the distribution of hedge funds by size.

Chart 12: Size distribution of hedge funds

0

5

10

15

20

25

30

35

<5m 5-25m 25-100m 100-500m >500mSize bucket (US$m)

No. o

f fun

ds (%

)

1999 2000 2001

Source: Van Hedge Fund Advisors

The size distribution was fairly constant over the past three years. Around 80% ofall funds under management were allocated to funds below US$100. The number offunds smaller than US$25 million has (somewhat counter-intuitively) fallen from52 percent and 54 percent in 1999 and 2000, to 45 percent in 2001. According toPeltz (1995) the breakdown in 1994 was that 72 percent of managers hadUS$50 million or less, 9 percent between US$50 million and US$100 million, 14percent between US$100 million and US$1 billion, and around 5 percent aboveUS$1 billion. The average size of hedge funds is decreasing. Based on the 1,305hedge funds in the MAR/Hedge database (not shown in Chart 12), the average fundsize in October 1999 was US$93 million, compared with US$135 million a yearearlier.


23 UBS Warburg

Industry breakdown by styleTable 3 shows an estimate of assets under management by style as of the secondquarter of 2002.

Table 3: Style allocation

1993 1994 1995 1996 1997 1998 1999 2000 2001 Q2 2002

Long/short equity 23.9 26.2 29.6 30.2 29.3 33.4 45.1 49.0 44.3 42.6

Event driven 10.7 12.7 12.9 14.9 15.9 17.2 16.0 17.7 19.6 19.4

Global macro 42.9 31.6 30.4 26.4 26.0 23.6 15.2 9.7 9.2 9.3

Convertible arbitrage 1.7 1.4 1.7 2.8 3.6 4.5 4.3 5.5 7.9 8.6

Equity market neutral 1.1 1.8 2.2 2.6 3.0 4.4 4.8 6.0 6.7 6.8

Fixed income arbitrage 3.9 6.7 7.5 8.4 8.5 7.5 6.0 5.2 5.4 5.7

Emerging markets 10.3 12.6 9.6 9.6 9.5 4.6 4.6 3.2 3.1 3.4

Managed futures 5.2 6.3 5.6 4.4 3.5 4.1 3.4 2.9 2.9 3.2

Dedicated short bias 0.23 0.35 0.25 0.25 0.25 0.36 0.33 0.34 0.28 0.27

Other 0.08 0.30 0.23 0.52 0.38 0.39 0.38 0.35 0.47 0.79

Source: Tremont Advisers

■■■■ Long/short equity is still the largest style, with a market share of around 43percent based on assets under management.

■■■■ The small weight decrease from 2001 to second quarter 2002 in equitylong/short and event-driven, and the weight increase in macro and managedfutures are primarily a function of performance.


24 UBS Warburg

Industry breakdown by investor typeTable 4 shows an estimated breakdown by investor type for US and non-USinvestors, as well as the combined investor base. The investor breakdown estimates(last two columns) are from Hedge Fund Research, Inc. These estimates incombination with an estimate for total assets under management in the industry,plus an assumption for the geographic breakdown, allow the estimation of investorbreakdown in absolute US dollar terms. Our assumption for a geographicbreakdown in terms of assets under management between US and non-US was 50percent held by US investors and 50 percent by non-US investors. The figures inTable 4 are estimates and are not consistent with all available surveys.

Table 4: Breakdown by investor type and location

All

investors

(US$ bn)

US

investors

(US$ bn)

Non-US

Investors

(US$ bn)

US

investors

(%)

Non-US

investors

(%)

Total* 600.0 300.0 300.0 100.0 100.0

Individuals 169.5 120.0 49.5 40.0 16.5

Fund of Funds 111.8 34.5 77.3 11.5 25.8

Banks 75.8 6.0 69.8 2.0 23.3

Pension Plans 46.5 31.5 15.0 10.5 5.0

Family Offices 32.6 16.1 16.5 5.4 5.5

Corporate Account 31.5 21.0 10.5 7.0 3.5

Endowments 22.5 22.5 NA 7.5 NA

Foundations 19.8 10.1 9.8 3.4 3.3

Insurance 16.1 6.3 9.8 2.1 3.3

General Partner 13.8 3.8 10.1 1.3 3.4

Trust 6.8 6.8 NA 2.3 NA

Mutual Fund 3.0 3.0 NA 1.0 NA

Other 50.6 18.6 32.0 6.2 10.7

Source: Hedge Fund Research, UBS Warburg* Assuming 50:50 breakdown between US and non-US investors and US$600 billion total under management.Last two columns are HFR estimates. US figures are based on 160 responses representing US$4.09 billion in hedge fund assets. Non-US figures are based on 169 responsesrepresenting US$4.55 billion in hedge fund assets.

The main difference between US and non-US investors has to do with theinvolvement of banks in the industry. US banks hold only around 2.0 percent ofhedge fund assets, whereas rest of world (RoW) banks hold around 23.3 percent.The fund of funds allocation is also larger outside the US. Assuming hedge fundassets are US$600 billion globally, then funds of funds, banks, and pension planshold US$111 billion, US$76 billion, and US$47 billion respectively. However, thelargest investor group is individuals, who hold around US$170 billion (28 percent)of hedge fund assets.


25 UBS Warburg

ConclusionSome investors in the hedge fund industry argue that the pursuit of absolute returnsis much older than the pursuit of relative returns (ie, beating a benchmark). Thisview can be justified if we allow for a loose interpretation of historical deals. Weconclude that the way hedge funds manage assets is going back to the roots ofinvesting. What Charles Ellis (1998) calls trying to win the loser’s game, therefore,could be viewed as only a short blip in the evolution of investment management.

Irrespective of the history of hedge funds or whether hedge funds are leading orlagging the establishment, the pursuit of absolute returns is probably as old ascivilisation and trade itself. However, so is lemming-like trend following.


26 UBS Warburg

ReferencesBloomberg News (1998) ‘Warren Buffett Invested $270 Million in Bond Hedge Fund in July,’ by Katherine Burton (15October).

Bloomberg News (2002) ‘Hennessee Releases 8th Annual Hennessee Hedge Fund Manager Survey’ (March 7).

Caldwell, Ted (1995) ‘Introduction: The Model for Superior Performance,’ In Jess Lederman and Robert A. Klein, eds.,Hedge Funds. New York: McGraw-Hill.

Caldwell, Ted, and Tom Kirkpatrick (1995) ‘A Primer on Hedge Funds,’ Courtesy of Lookout Mountain Capital, Inc.

Eichengreen, Barry, and Donald Mathieson (1998) ‘Hedge Funds and Financial Market Dynamics,’ Occasional PaperNo. 166. Washington, DC: International Monetary Fund (May).

Elden, Richard (2001) ‘The Evolution of the Hedge Fund Industry,’ Journal of Global Financial Markets, Vol. 2, No. 4(Winter), pp. 47--54.

Ellis, Charles D (1998) ‘Winning the Loser’s Game: Timeless Strategies for Successful Investing,’ 3rd edition. NewYork: McGraw-Hill.

Financial Times (2002) “Equity Investments by Pension Funds Projected to Surge,” by Paul Taylor, (March 4). Articlemakes reference to study titled “Pension Reform and Global Equity Markets,” by Birinyi Associates.

Frauenfelder, Eduard (1987) ‘Optionen in Wertpapieren und Waren,’ 2nd edition. Bern: Verlag Paul Haupt.

Gastineau, Gary L. (1988) ‘The Options Manual,’ 3rd edition. New York: McGraw-Hill.

Hagstrom, Robert G, Jr (1994) ‘The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor,’ NewYork: John Wiley & Sons.

Ineichen, Alexander M (2002) ‘Absolute Returns – Risk and Opportunities of Hedge Fund Investing,’ forthcoming, JohnWiley & Sons, New York.

Neill, Humphrey B (2001) ‘The Art of Contrary Thinking – It pays to be contrary!’ Fifth and Enlarged Edition, Caldwell:Caxton Press. First published 1954.

Peltz, Lois (1995) ‘Track Record Length: The Ins and Outs of Hedge Fund Size,’ In Jess Lederman and Robert A. Klein,eds., Hedge Funds. New York: McGraw-Hill.

Persaud, Avinash (2001) ‘Liquidity Black Holes,’ State Street Working Paper (December.)

Rohrer, Julie (1986) ‘The Red-Hot World of Julian Robertson,’ Institutional Investor (May), pp. 86–92.

Shiller, Robert J (1990) ‘Market Volatility and Investor Behavior,’ American Economic Review, Vol. 80, No. 2, pp. 58-62.

Smith, Roy C, and Ingo Walter (1997) ‘Street Smarts—Linking Professional Conduct with Shareholder Value in theSecurities Industry,’ Boston: Harvard Business School Press.

Soros, George (1987) ‘The Alchemy of Finance: Reading the Mind of the Market,’ New York.: John Wiley & Sons.

Train, John (1981) ‘The Money Masters,’ New York: Penguin Books.

UBS Warburg (2000) ‘In Search of Alpha – Investing in Hedge Funds’ UBS Warburg global equity research, October.

UBS Warburg (2001) ‘The Search for Alpha Continues – Do Fund of Hedge Funds Managers Add Value?’ UBSWarburg global equity research, September.

UBS Warburg (2002a) ‘Managing the Curve – Improving risk-adjusted returns,’ UBS Warburg global equity research,September.

UBS Warburg (2002b) ‘Asymmetric returns,’ UBS Warburg global equity research, 30 September.


27 UBS Warburg

Performance updateThe shorts go marching onChart 13: Ytd returns from a selection of hedge fund strategies

-47.2

-25.3

-13.6

-7.7

-6.9

-4.7

-4.0

-4.0

-2.8

-2.8

-0.4

2.8

4.0

8.2

9.1

32.1

-60 -50 -40 -30 -20 -10 0 10 20 30 40

NASDAQ 100 Index

MSCI World (US$, total return)

Equity Non-Hedge Index

Equity Hedge Index

Event-Driven Index

Emerging Markets (Total) Index

Fund Weighted Composite Index

Statistical Arbitrage Index

Merger Arbitrage Index

Market Timing Index

Distressed Securities Index

Equity Market Neutral Index

Convertible Arbitrage Index

Macro Index

Fixed Income Arbitrage Index

Short Selling Index

Return 2001 Return 2002

Source: Hedge Fund Research, Datastream.Equity Non-Hedge Index: Long/short equity with long-biasEquity Hedge Index: Long/short equity where market risk is hedged or reduced

■■■■ The August gains in global equity markets turned out to be shortlived relief fromthe broader theme of falling equity values. September was dire for long-onlyequity investors as the MSCI World Index plummeted, producing a total returnfor the month of -11.1%.

■■■■ Yet again short sellers benefited from this situation. In fact, we are rapidlyrunning out of new and interesting ways to say that when markets go down,short sellers turn in strongb performances. we believe short selling is the onlyeffective hedge against harm to one’s wealth in a market like the current one.

■■■■ High volatility markets rarely benefit long-short investors, and in particularmarket neutral investors. However, we believe volatile markets can provide arich source of opportunity for market neutral and statistical arbitrageurs as gapscan open unexpectedly for reasons other than fundamental or relative valuegaps.

■■■■ Convertible bond arbitrageurs posted gains in August. Implied volatilitycontinued to rise, although falling equity values have now created anincreasingly large pool of what are effectively just bonds. Many outstanding


28 UBS Warburg

issues due to expire over the two to three years are so far out of the money thatwe believe they are highly unlikely to convert.

■■■■ While it is too early to feed through to September performance, merger activityis showing signs of picking up. Certainly the European financial services sectorcurrently provides at least one large opportunity for merger arbitrageurs – theyposted small negative returns in September.

■■■■ Fixed income arbitrageurs also posted strong results as credit spreads widened.This style has provided consistent, relatively unvolatile returns all year.September was the style’s twelfth consecutive month of positive returns.

■■■■ The market turbulence seems to suit macro players very well too. They postedthe best monthly result in September since December 2000.

Chart 14 compares annual returns of the MSCI World Total Return Index with theHFRI Fund of Funds Index.

Chart 14: Annual returns of MSCI World and HFRI Fund of Funds indices

17.514.5 12.3

26.3

-3.5

11.114.4

18.0

-5.1

26.5

4.1 2.8 0.7

-30

-20

-10

0

10

20

30

40

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Annu

al tot

al re

turn (

%)

MSCI World (4.2% p.a.) HFRI Fund of Funds Index (10.5 p.a.)

Source: Hedge Fund Research, DatastreamBoth indices are total returns in US dollars, August 2002 inclusive.

■■■■ The current outlook for calendar year 2002 continues to be similar to 2000 and2001 in our view – large losses in equities and below-average returns in hedgefunds.

Chart 15 compares the recent performance of some long-only indices and aselection of hedge fund indices with its trading range. The wide horizontal markmeasures the rolling 12-month total return, while the narrow mark measures thelong-term mean. The vertical line measures the trading range of the rolling12-month return since January 1990.


29 UBS Warburg

Chart 15: Rolling 12-month returns compared with trading range

-60

-40

-20

0

20

40

60

80

100

S&P 5

00MS

CI Worl

dMS

CI EA

FEMS

CI Eu

rope

JPM

Glob

al Bo

nds

CB Ar

bitrag

e

Fixed

Inco

me Ar

bitrag

eEq

uity M

arket

Neutr

alRis

k Arbi

trage

Distre

ssed S

ecuri

ties

Macro

Equit

y Hed

geEq

uity N

on-H

edge

Emerg

ing M

arkets

Short

Sellin

gFu

nd of

Fund

s

12-m

onth

tota

l ret

urn

(%)

Current 12-month return Mean 12-month return

Traditional Alternative

Source: Hedge Fund Research, DatastreamBased on total returns in US dollars: January 1990-August 2002.

■■■■ The mean returns to relative value strategies have been similar to equity indiceswith volatilities similar to bond indices.

■■■■ The macro and equity hedge indices have a similar dispersion of returns toequity indices on the upside, but less erratic swings on the downside. Thisasymmetry (avoiding negative compounding) results in higher mean returns.

■■■■ The current 12-month return is below the long-term mean for all indices exceptbonds and short sellers. Fixed income arbitrage returned to an above averageposition as well, having slipped slightly below average in August from an aboveaverage position at the end of July.

■■■■ Rolling 12-month returns for risk arbitrage came off all-time lows in September.


30 UBS Warburg

Table 5 shows an update of a selection of HFR (Hedge Fund Research) indicescompared with traditional asset classes. The second column from the right measuresthe number of years it takes at the historical growth rate (first column) to reach theprevious all-time high.

The last column then measures the month and year in which the losses have beenrecovered. The recovery period for the MSCI EAFE Index may now exceed theremaining life expectancy of the authors of this document and, we suspect, many ofour readers.

Table 5: HFRI performance update

Annual

return

(%)

Volatility

(%)

Sharpe

ratio*

Highest

1M loss

(%)

Negative

months

(%)

Worst 1Y

return

(%)

Loss

recovery

(years)

Loss

recovery

(year)

S&P 500 (Total return) 9.2 15.1 0.28 -14.5 38 -26.6 4.9 08.2007

MSCI World (Total return) 4.2 15.0 <0 -13.3 41 -27.9 11.2 12.2013

MSCI EAFE (Total return) 0.7 17.2 <0 -13.9 44 -28.3 68.3 02.2071

MSCI Europe (Total return) 6.0 15.8 0.07 -13.2 40 -25.5 7.5 04.2010

JPM Global Bond Index (Total return) 7.3 6.0 0.39 -3.3 40 -6.2 0.0 at high

HFRI Convertible Arbitrage Index 11.5 3.4 1.91 -3.2 13 -3.8 0.0 10.2002

HFRI Distressed Securities Index 14.1 6.4 1.43 -8.5 21 -6.4 0.3 02.2003

HFRI Emerging Markets (Total) Index 13.0 16.2 0.49 -21.0 35 -42.5 1.1 11.2003

HFRI Equity Hedge Index 18.3 9.3 1.43 -7.7 29 -8.3 0.6 05.2003

HFRI Equity Non-Hedge Index 15.0 14.9 0.67 -13.3 37 -21.7 1.9 08.2004

HFRI Equity Market Neutral Index 10.7 3.2 1.76 -1.7 15 1.6 0.0 10.2002

HFRI Event-Driven Index 18.5 9.3 1.44 -7.7 27 -4.8 0.4 03.2003

HFRI Fixed Income: Arbitrage Index 8.8 4.7 0.82 -6.5 19 -10.4 0.0 at high

HFRI Macro Index 17.3 8.7 1.42 -6.4 30 -7.1 0.0 at high

HFRI Market Timing Index 13.5 6.9 1.24 -3.3 35 -3.3 0.3 01.2003

HFRI Merger Arbitrage Index 11.2 4.6 1.35 -6.5 14 -3.5 0.4 02.2003

HFRI Relative Value Arbitrage Index 13.2 3.8 2.14 -5.8 12 1.1 0.0 at high

HFRI Statistical Arbitrage Index 9.7 4.0 1.17 -3.0 25 -1.3 0.4 03.2003

HFRI Sector: Technology Index 19.3 20.5 0.70 -15.2 40 -37.6 2.7 07.2005

HFRI Short Selling Index 4.0 22.8 <0 -21.2 48 -38.0 0.0 at high

HFRI Fund Weighted Composite Index 14.5 7.3 1.31 -8.7 27 -6.4 0.4 03.2003

HFRI Fund of Funds Index 10.5 5.9 0.93 -7.5 26 -6.6 0.2 12.2002

Source: Hedge Fund Research, Inc., Datastream

Based on US$ total returns since January 1990

* based on risk free rate of 5%


31 UBS Warburg

Global ratings: Definitions and allocations

UBS rating Definition Rating category1 Coverage2 IB services3

Strong Buy Greater than 20% excess return potential; high degree ofconfidence Buy 53% 40%

Buy Positive excess return potentialHold Low excess return potential; low degree of confidence Hold/Neutral 42% 26%Reduce Negative excess return potential

Sell Greater than 20% negative excess return potential; highdegree of confidence Sell 5% 18%

Excess return: Target price / current price - 1 + gross dividend yield - 12-month interest rate. The 12-month interest rate used isthat of the company's country of incorporation, in the same currency as the predicted return.1: UBS Strong Buy/Buy = Buy; UBS Hold = Hold/Neutral; UBS Reduce/Sell = Sell.2: Percentage of companies under coverage globally within this rating category.3: Percentage of companies within this rating category for which investment banking (IB) services were provided within the past12 months.

Source: UBS AG, its subsidiaries and affiliates; as of 30 September 2002.


32 UBS Warburg

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