hedge fund industry: is there a capacity effect?

Edhec Risk and Asset Management Research Centre

Hedgefund

industry: is there a

capacityeffect?

Rudy Sillam

July 2005

Foreword 1

Executive summary 2

Hedge fund industry: is there a capacity effect? 3

Introduction 3

Survey methodology 5

Have some strategies reached saturation point? 6

The alpha problem 7

Talented managers 9

Size effect? 9

Conclusion 10

References 11

Appendix: Statistical results 12

Edhec Risk and Asset Management Research Centre 20

Copyright © Edhec 2005

CONTENTS

For several months, investors and their advisorshave been worrying about the profitability

prospects for hedge funds.

Modestly entitled the "capacity effect", the analysis ofthe reasons behind the fairly disappointingperformance in 2004 constitutes, if we believe thosewho are putting the argument forward, a seriouscalling into question of the alternative investmentindustry's value proposition. Alphas would be tendingto become rarer, for two main reasons:

The significance of the sums drained into thealternative investment industry are making theimplementation of "niche arbitrage" strategiesmore and more difficult (for example, convertiblebonds or arbitrage on small stocks); more globally,the increase in operational volumes is reducingmarket inefficiency and market anomalies, whichare allegedly the main source of performance forhedge funds.

The windfall represented by the remunerationmodel and the very strong growth in assets undermanagement is attracting more and moremanagers, which is leading to a dilution of thetalent available in the industry. The"democratisation" of hedge funds is making themincreasingly dull.

However, this pessimism doesn't hold up when weexamine the facts. It is related more to the incapacityon the part of both investors and managers tounderstand or explain the true benefits of investmentin hedge funds than to the capacity effect.

The capacity problem that is supposedly linked to thedisappearance of arbitrage opportunities has not beendemonstrated and cannot, in our opinion, bedemonstrated. On the one hand, the alternativeindustry, even taking the leverage effects into account,represents less than 2% of worldwide stock marketcapitalisation and, on the other, even whenconsidering specific market segments (the rawmaterial derivatives market, stock loan/borrowingmarket, etc.), it is true that one can reach verysignificant proportions of activity relating to theintervention of hedge funds, representing up to 30% ofoperations on certain stocks or up to 50% of someopen positions, but these volumes rarely correspond toarbitrage operations. They generally involve bets thatare directional (CTA, Global Macro) or related to theunfolding of events on securities that by definition areintended to move between market segments in

accordance with speculative opportunities. In certainsituations, hedge fund profits can be limited by thedepth of the market, but it is not strictly speaking areduction in inefficiency, simply a concern on the partof managers not to be the only providers of liquidity.

It has not been demonstrated either that the newentrants into the industry have less talent than theinitial entrants. Academic research and empirical workon the "age" effect on hedge fund performance givesconflicting results. Besides, estimating a hypotheticalincrease in the number of fund failures is not possibleeither, given the reporting biases and theinsufficiencies of databases in this area.

In fact, the essential part of hedge fund performancecomes from their betas. Their talent resides in themanagement of those betas, namely, correctly takingrisks for which the premiums, i.e. the "normal"returns, are less easy to capture in the equity and bondmarkets. Allowing investors, for example, to accessthe credit and volatility markets in good timing andprice conditions undeniably constitutes added valuewhich justifies turning to specialists.

Even the performances of so-called "Relative Value"strategies such as Long/Short Equity and EquityMarket Neutral are conditioned by bets on particularrisks like, for example, the evolution of the Large Cap- Small Cap spread.

By constantly highlighting arbitrage alphas that aredifficult to measure, hedge funds have themselvesfallen into the trap of the capacity effect, with the riskof forgetting their true virtue - that of offering newbetas to investors who are always looking for effectivediversification.

The aim of the current survey, which follows a recentEdhec research paper by Walter Géhin and MathieuVaissié entitled “The Right Place for Alternative Betasin Hedge Fund Performance: an Answer to theCapacity Effect Fantasy”, was to check whether theopinions on the capacity effect of the financeprofessionals in the field, and their views on the realsources of hedge fund performance, corresponded tothe results of our research in this area.

Noël Amenc, PhDProfessor of Finance at Edhec & Director of theEdhec Risk and Asset Management Research Centre

FOREWORD: Capacity Effect or Incapacity Effect?

1Hedge fund industry: is there a capacity effect?

EXECUTIVE SUMMARY

Introduction

Following recent studies claiming that the hedgefund industry will suffer from a capacity effect,

the Edhec Risk and Asset Management ResearchCentre published a paper entitled "The Right Placefor Alternative Betas in Hedge Fund Performance:an Answer to the Capacity Effect Fantasy", whichrefuted the idea of capacity constraints within theindustry and promoted the importance ofalternative betas in hedge funds' returns, rather thanfocusing exclusively on alpha. In order to analysethe opinions of industry professionals andacademics, we decided to conduct a survey to try torespond to the question: Is there a capacity effectwithin the industry?

Market capacity

Most of our respondents think that onlyrelative value arbitrage strategies suffer or

will suffer from a capacity constraint. These resultsare in line with the impact of hedge funds indifferent markets, with overall hedge fund industryassets representing no more than 3% of worldwidefinancial assets, but accounting for up to 90% of thetrading in the markets for relative value arbitragestrategies. Moreover, our respondents are confidentabout the growth prospects of the industry, withmore than 65% expecting double-digit annualgrowth rates.

The Alpha problem

While investors seem preoccupied with theproblem of alpha, they are aware of where

hedge fund performance comes from.Approximately half of the respondents think thatalpha is the main source of performance within theindustry, but 95% of the respondents think thatalpha is overestimated and they are aware of hedge funds' exposures to alternative betas as a source ofreturn (69.8% of our respondents). Moreover, as the

study by Gehin and Vaissié (2005) has shown, mostof the respondents agree that alternative betas are predominant in relative value arbitrage strategies,and they find that cyclical factors (for 69.7% of ourrespondents), rather than a disappearance of "purealpha", explain the disappointing performance thatthese strategies have experienced recently.

Manager capacity and size effect

While a market capacity problem seems to berefuted by our respondents, the results

regarding the problem of manager capacity aremixed. Although the industry does not suffer froma shortage of talent, the huge growth in the numberof hedge funds has increased the difficulty ofselecting talented managers. Moreover, ourrespondents do not think that a critical hedge fundsize exists within the industry.

Conclusion

The results of our survey show that the hedgefund industry is not suffering from a capacity

constraint but is facing new challenges. The hedgefund industry has to understand that returns comemore from the exposure to alternative riskpremiums rather than alpha, and that the mainadvantages to investing in hedge funds relate totheir diversification benefits with traditional assets(approximately 60% of our respondents invest inhedge funds for their diversification benefits withtraditional assets). Moreover, the industry ismaturing and becoming more competitive as 81%of our respondents claim. With professionalism andinnovation, the hedge fund industry is more likelyto keep growing and create high and stable returns.

2 Hedge fund industry: is there a capacity effect?

During the last five years, the hedge fundindustry has experienced tremendous growth,

with an average annual growth rate of 15%.According to Van Hedge Fund Advisors, theindustry went from 6,200 funds representing $480billion in assets under management (AUM) in 1999to 8,700 funds representing $950 billion in AUM atthe end of 2004. Moreover, analysts forecast thatthe industry will represent $1.7 trillion in assets in2008 with more than 11,000 funds. The current8,700 funds use different strategies, naturally, tomanage their assets. Among these strategies,Long/Short Equity represents more than 33% ofhedge fund industry assets (see exhibit 1).

HEDGE FUND INDUSTRY: IS THERE A CAPACITY EFFECT?

3

Exhibit 1: Breakdown of assets under management by strategy in the hedge fund universe

11%7%

5%

7%

15%7%0%

33%

0% 8%

7%Convertible Arbitrage CTA GlobalEmerging Markets Equity Market NeutralEvent Driven Fixed Income ArbitrageFunds of Funds Global MacroLong/Short Equity Short SellingOther

Source: Hedge Fund Research, Watson Wyatt (2005)

Introduction

Hedge fund industry: is there a capacity effect?

After good returns in 2003 (11.45% for the EDHECFund of Funds Index, see exhibit 2), the industryhas experienced decreasing positive performance in2004 (7.08% for the EDHEC Fund of Funds Index)with even negative returns in the second quarter of2004. These returns, confirmed by the returns ofApril 2005, have led some investors to talk about acapacity effect in the industry, claiming that theindustry is a victim of its success and therefore thatmarket opportunities will disappear and talentedmanagers will be more difficult to find.

The four major arguments behind this supposedcapacity effect are the following:

In some strategies, the huge number of playershas reduced market opportunities

Due to the capacity constraint, alpha isdisappearing

There is a shortage of talent in the industry tocope with the growth of assets

Size is becoming a problem

In order to analyse the arguments relating to theproblem of capacity in the industry, we conducted asurvey among investment professionals who have aninterest in the hedge fund industry. The resultsproduced by our survey are in line with those of theGehin and Vaissié study, "The Right Place forAlternative Betas in Hedge Fund Performance: anAnswer to the Capacity Effect Fantasy", whichaffirmed that the reduction in the number of marketopportunities and the capacity effect are falseproblems and that recent disappointing performancescome more from cyclical factors (for 69.7% of ourrespondents) than a reduction in market opportunitiesand more generally that hedge fund performancecomes more from exposure to alternative risk factors(alternative betas) than from pure alpha.

Exhibit 2: Historical returns of EDHEC Indices by strategy

Edhec Indices Y 2002 Y 2003 Q2 2004 Y 2004 Q1 2005 April 2005

AnnualAverageReturnsince

InceptionConvertibleArbitrage 8.60% 10.80% -2.13% 1.10% -2.91% -3.16% 6.18%

CTA Global 14.57% 11.64% -9.39% 5.17% -4.39% -3.54% 6.31%

DistressedSecurities 5.86% 27.34% 2.87% 17.89% 2.04% -0.52% 14.36%

Emerging Markets 5.76% 31.27% -4.09% 14.30% 2.87% -0.49% 14.32%

Equity MarketNeutral 4.71% 6.29% -0.16% 4.71% 1.81% -0.30% 5.72%

Event Driven -1.08% 20.48% 0.92% 12.43% 1.44% -1.28% 8.98%

Fixed IncomeArbitrage 7.56% 8.35% 1.58% 6.26% 1.54% -0.03% 7.06%

Funds of Funds 1.26% 11.45% -1.16% 7.08% 0.97% -1.41% 5.12%

Global Macro 4.96% 17.25% -2.76% 4.60% 0.96% -0.80% 7.20%

Long/Short Equity -6.38% 19.31% -1.10% 8.62% 0.95% -1.84% 4.16%

Merger Arbitrage -0.90% 8.34% -0.22% 4.83% 0.97% -1.05% 3.41%

Relative Value 2.77% 12.15% -0.60% 5.71% 0.51% -1.08% 6.41%

Short Selling 27.27% -23.87% 3.06% -4.66% 7.66% 3.93% 4.20%

4

Source: Edhec Risk and Asset Management Research Centre


In this survey, conducted from May 31st to July8th 2005, we sent out an email to financial

professionals informing them that ourquestionnaire was available atwww.formdesk.com/edhecrisk/capacityeffect andasking them to participate in the survey.

We collected 183 responses, of which 65.6% workin funds of hedge funds and 10.9% in hedge funds.11.5% of our respondents are institutional investorsand 12% work in a consulting or research company(see exhibit 3). Statistical results are given in theappendix.

5

Survey Methodology

11.5%

65.6%

10.9% 12.0%

Institutional Investors Hedge Funds

Exhibit 3: Breakdown of respondents by category

Funds of Hedge Funds Others (advisors, consultants…)



http://www.formdesk.com/edhecrisk/capacityeffect

To the question, "Of the following strategies,which suffer or will suffer from a capacity

constraint?", results show that relative valuearbitrage strategies may suffer from a capacity effect.Indeed, for 83.2% and 65.92% of the respondentsrespectively, the convertible arbitrage and mergerarbitrage strategies suffer from a capacity constraint(see graph 9 below). Moreover, for 70.9% of therespondents, arbitrage opportunities have beenreduced and will be difficult to exploit (see graph 8below). These results are in line with the impact ofhedge funds in different markets.

Even if the hedge fund industry represents $1 trillionin assets today, the size of the industry remains smallin comparison with the overall asset managementindustry. According to UBS, the worldwide financialmarket (equities + bonds) represents $87.4 trillion inassets, which means that the hedge fund industryrepresents only 1.1% of total financial assets.Moreover, if we include the use of leverage, theindustry still represents no more than 3% of totalfinancial assets. For instance, hedge fund investing inequities represents a mere 2% of the equity market.

If we look at relative value strategies, some arbitragestrategies can represent a huge share of the assets andtrading. For example, convertible arbitrage fundsaccount nowadays for 70% to 90% of the trading inthe convertible market, and in 2004 and the firstquarter of 2005 the strategy has experienced its worstreturns since the LTCM crisis in 1998 (annual returnof 1.1% for the EDHEC Convertible Arbitrage indexin 2004 and a negative return of -2.91% for the firstquarter 2005 against an historical average annualreturn of 6.18%). Market opportunities seem to havebeen eroded in these markets and "pure alphas" maybe more difficult to find due to the huge number ofplayers.

However, we have to note that professionals seemconfident about the future of the industry and itscapacity to keep growing. More than 65% of therespondents (see graph 2 below) think that industryassets will grow at a minimum annual rate of 10%over the next five years with a large number ofrespondents putting this growth at between 10% and15%.

The main reasons behind this belief that the industrywill continue to grow at a double-digit annual rate arethe capital inflows from institutional investors andthe increase in regulation (48% of respondents) andthe benefits of hedge funds in comparison withtraditional investment (20%). We should recall thatthe growth of the industry during the past five yearswas 15% per year. Therefore, most people expect tosee the industry continue to grow at the same rate.

Have some strategies reachedsaturation point?


For those claiming that the industry is sufferingfrom a capacity constraint, the main problem

would seem to be that alpha (manager skill) isbecoming rarer. The results of our survey show thatwhile investors seem preoccupied with the problemof alpha, the main concern in the industry now is toevaluate this alpha and to understand the benefits ofhedge funds.

We have seen previously that "pure alphas" seem tobe difficult to find because some strategies may beovercrowded. However, no more than 53.3% of therespondents think that alpha is the main source ofperformance within the industry (see graph 3below). Moreover, 95% of the respondents thinkthat alpha, through poor measurement of differentrisk exposures, could be overestimated (see graph 6below), showing that alpha is not such a majorsource of returns and that exposure to different riskexposures plays an important role in explainingreturns. As Fung (2003) says,

" hedge funds deliver alternative risk premiafor bearing risk in factors different fromtraditional investment ",

by for instance being exposed to volatility risk,default risk or liquidity risk.

Indeed, 69.8% of respondents are aware of"alternative betas" i.e. betas coming from exposureto risk factors other than market risk (see graph 4below). Not surprisingly, 74% of the respondentswho are aware of alternative betas claim thatalternative betas are predominant in relative valuearbitrage strategies, mainly in convertible arbitrage(58.33%, see graph 5 below) and fixed incomearbitrage strategies (50%). Therefore, we canwonder whether the disappointing performance thatthese strategies have experienced recently are dueto a reduction in the risk premiums with regard tothe systematic risks that these funds are taking(credit risk, volatility risk, etc., see exhibit 4) ratherthan to "pure alpha" that would be becomingdifficult to produce due to a shortage of marketopportunities and to overcrowding in thesestrategies. These results confirm the analysis inGehin and Vaissié (2005), which indicated that103.17% and 95.81% of the performance level ofConvertible Arbitrage funds and Fixed IncomeArbitrage funds, respectively, comes from theirexposures to static betas (see exhibit 5).

The alpha problem


Exhibit 4: Exposure torisk factors by strategyFrom January 1997 to

December 2004

Equity Factors Bond Factors Other

Impl

ied

vola

tility

(VIX

)

Cha

nge

in I

mpl

ied

Vola

tility

(VIX

)

Valu

e ve

rsus

Gro

wth

Cha

nge

in V

alue

Ver

sus

Gro

wth

Smal

l Cap

ver

sus

Lar

ge C

ap

Cha

nge

in S

mal

l Cap

ver

sus

Lar

ge C

ap

S&P

500

Term

Spr

ead

Cha

nge

in T

erm

Spr

ead

Cre

dit S

prea

d

Cha

nge

in C

redi

t Spr

ead

Leh

man

Glo

bal B

ond

Inde

x (B

ond

Ret

urn)

His

tori

cal V

olat

ility

in B

ond

Ret

urn

T-B

ill 3

Mon

ths

US

Dol

lar

Com

mod

ity I

ndex

Equity Market Neutral + + + + + - - + +Fixed Income Arbitrage + + - - -Convertible Arbitrage + - + - + +Merger Arbitrage + + + + - - - +Distressed Securities + - + + -Long/Short Equity + + - + + - - - +Global/Macro + + + - + - - + -CTA Global + - - + + - +Emerging Markets + + + + -


Exhibit 5: Decomposition of Hedge Fund Strategies' Return VariabilityFrom January 1997 through December 2004

Investment Styles Static Betas Dynamic Betas Pure Alpha Total

Convertible Arbitrage 42.13% 21.15% 36.72% 100.00%

CTA Global 26.97% 34.60% 38.43% 100.00%

Distressed Securities 66.76% 8.62% 24.62% 100.00%

Emerging Markets 60.91% 14.74% 24.35% 100.00%

Equity Market Neutral 51.53% 27.37% 21.09% 100.00%

Fixed Income Arbitrage 37.28% 36.32% 26.39% 100.00%

Global Macro 35.49% 34.52% 29.99% 100.00%

Long/Short Equity 83.06% 9.25% 7.70% 100.00%

Merger Arbitrage 59.51% 26.21% 14.29% 100.00%

Average 51.52% 23.64% 24.84% 100.00%



Size effect?Talented managers

The third argument behind the problem ofcapacity constraint within the industry would

be that the industry suffers from a lack of talentedindividuals. According to Watson Wyatt (2005), nomore than 10% of current hedge fund managers arehighly skilled. With the increase in the number offunds and the fact that many managers with goodtrack records are closed to new investment, theargument would be that fund of hedge fundsmanagers would have more difficulty findingtalented hedge fund managers only and their futurereturns would be expected to go down.

The results of our survey show mitigated opinions.59.3% of respondents find it difficult today to selecttalented managers (see graph 10 below), but only36.3% of the respondents claim that the managercapacity constraint is an important threat to returnsin the industry (see graph 11 below). It appears thatthe industry suffers more from the proliferation offunds, which leads investors to improve their fundselection process in order to find talentedmanagers, rather than from a shortage of talentedmanagers.

Even if research on the "age" and "size" effectshows varying results, an argument of those

alleging that the industry suffers from a capacityeffect is that size would impact the fundperformance and therefore that there would be acritical size for a fund.

Our results seem to refute this idea. Half of therespondents think that there is no size limit for afund of hedge funds, whereas the other half thinksthat a critical size exists (see graph 13 below).However, those who think that a critical size existsdiffer in their definition of the critical size (seegraph 14 below). For 23.2% of these respondentsthe critical size of the fund of hedge funds dependson the underlying strategies. For 18.3% the size isaround $500 million and for 22% the critical size isbetween $1 billion and $2 billion.

40.2% of the funds of hedge funds questioned arewilling to buy or merge with a competitor in orderto gain capacity in the industry (see graph 15).


CONCLUSION

Capacity constraint in the hedge fund industryis currently a matter of concern to investment

professionals. However, as the results of our surveyshow, the industry does not suffer from a capacityconstraint but is facing new challenges.

69.8% (see graph 7 below) of our respondentsconsider that cyclical factors were among the mainreasons behind recent lower-than-expected returns(for 42.3% of our respondents cyclical factors werethe only reason). This corresponds to theconclusions of Fransolet and Loeys (2004), forwhom many of the current low returns of hedgefunds are due to cyclical factors which prevent theemergence of momentum or large mispricingopportunities (no major change in economic views,low volatility, high correlation in markets, lowcredit spreads, etc.).

Investing in hedge funds offers several benefits buthas its risks. Hedge fund managers are notmagicians who provide excess returns withouttaking any risk. They are managers who createreturns by exploiting alternative risk premiums andoffer the benefits of diversification for an investor'sportfolio (for 53.5% and 47.7% of our respondentsrespectively, the benefits of hedge funds come fromtheir diversification benefits with equities andbonds, see graph 1 below).

Moreover, the hedge fund industry is maturing andbecoming more competitive, with institutionalinvestors' current interest in the industry, the highfees that have characterised the business andincreasing regulations. As 81.3% of ourrespondents acknowledge (see graph 12 below), thehedge fund industry is becoming moreprofessional. With professionalism and innovation,the industry is more likely to keep growing andcreating high and stable returns. However, as Lo(2004) says,

" new opportunities are constantly beingcreated as certain species die out, asothers are born, and as institutions andbusiness conditions change ".

By exploiting opportunities in different marketsand therefore increasing liquidity in these markets,hedge funds reduce some opportunities, but at thesame time create new ones.


REFERENCES

Géhin, W. and Vaissié, M., "The Right Place forAlternative Betas in Hedge Fund Performance: anAnswer to the Capacity Effect Fantasy", EdhecRisk and Asset Management Research Centre, June2005.

UBS, "The Critique of Pure Alpha", March 2005.

Watson Wyatt, "Capacity in the Hedge FundIndustry", March 2005.


Graph 1

1. If you invest in hedge funds, why do you do so?

47.7%

21.8%

32.9%

21.2%

10.6%

53.5%

60.0%

0%

10%

20%

30%

40%

50%

60%

70%

For their diversification benefits with

bonds

For their diversification benefits with

equities

Hedge funds offer absolute

returns

Better performance on average than that of traditional

funds

The volatility of hedge fund performance is lower than

that of traditional

assets

The potential for maximal loss is lower

than for traditional

assets

Other

% r

espo

nden

ts

Graph 2

2. At what average annual rate do you expect hedge fund industry assets to grow over the next 5 years?

2.2% 6.0%

25.8%

36.3%

20.3%

6.0% 3.3%

0% 5%

10% 15% 20% 25% 30% 35% 40% 45% 50%

Less than 0%

Between 0% and

5%

Between 5% and

10%

Between 10% and

15%

Between 15% and

20%

Between 20% and

25%

More than 25%

Expected growth

% r

espo

nden

ts

APPENDIX: STATISTICAL RESULTS


Graph 3

3. To your mind, is alpha (manager skill) the main source of performance within the hedge fund industry?

53.3% 46.7%

0%

10%

20%

30%

40%

50%

60%

Yes No

% r

espo

nden

ts

Graph 4

4. Are you aware of what are referred to as “alternative betas” (betas coming from exposure to risk factors other than market risk)?

69.8%

30.2%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Yes No

% r

espo

nden

ts


Graph 5

5. Within which strategies do you think that alternative betas are predominant?

58%

50%

39%

28%

33%

28%

40%

31%

25% 26%29%

25%

0%

10%

20%

30%

40%

50%

60%

70%

Convert

ible A

rbitrage

Fixed Inc

ome A

rbitrage

Merger

Arbitra

ge

Relativ

e Valu

e

Distress

ed Secu

rities

Event D

riven

Long/S

hort Equ

ity

Equity

Mark

et Neutra

l

Short Sell

ing

Emerging M

arkets

Global M

acro

CTA Glob

al

% r

espo

nden

ts

Graph 6

6. Do you think that alpha, through poor measurement of different risk exposures, could be overestimated?

95.05%

4.95%

0% 10% 20% 30% 40% 50% 60%

70% 80% 90%

100%

Yes No

% r

espo

nden

ts


Graph 7

7. Do you think that the lower-than-expected returns in 2004 were due to cyclical factors or to capacity constraints?

42.3%

20.9%

27.5%

9.3%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Cyclical factors

Capacity constraints

Both Other

% r

espo

nden

ts

Graph 8

8. Do you think that arbitrage opportunities will be difficult to find in future years due to capacity constraints?

70.9%

29.1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Yes No

% r

espo

nden

ts


Graph 9

9. Of the following strategies, which suffer or will suffer from a market capacity constraint?

83%

10%

41%

15%

24%

41%45%

23%

5%

19%

66%

40%

11%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Convert

ible A

rbitrage

CTA Glob

al

Distress

ed Secu

rities

Emerging M

arkets

Equity

Mark

et Neutra

l

Event D

riven

Fixed Inc

ome A

rbitrage

Funds o

f Fun

ds

Global M

acro

Long/S

hort Equ

ity

Merger

Arbitra

ge

Relativ

e Valu

e

Short Sell

ing

% r

espo

nden

ts

Graph 10

10. Do you find it more difficult today to find talented hedge fund managers?

59.3%

40.7%

0%

10%

20%

30%

40%

50%

60%

70%

Yes No

% r

espo

nden

ts


Graph 11

11. What is the main threat for returns in the industry?

36.3%

43.4%

20.3%

0% 5%

10% 15% 20% 25% 30% 35% 40% 45% 50%

Manager capacity constraints

(manager skill)

Market capacity constraint

(size of the industry)

Other

% r

espo

nden

ts

Graph 12

12. Do you think that the hedge fund industry is becoming more professional?

81.3%

18.7%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Yes No

% r

espo

nden

ts


Graph 13

13. Do you think that there is a critical size for a fund of hedge funds?

50.55% 49.45%

0%

10%

20%

30%

40%

50%

Yes No

% r

espo

nden

ts

Graph 14

14. Critical size for a fund of hedge funds

12.2%

18.3%

12.2% 9.8% 8.5%

15.85%

23.2%

0%

5%

10%

15%

20%

25%

30%

35%

Less than $300

million

Around $500

million

Around $1 billion

Around $2 billion

Around $5 billion

Other size

Depends on the

strategies

% r

espo

nden

ts


19

Graph 15

15. If you are a fund of hedge funds, are you willing to buy or merge with a competitor in order to gain capacity in the industry?

40.2%

59.8%

0%

10%

20%

30%

40%

50%

60%

70%

Yes No

% r

espo

nden

ts


Edhec is one of the top five business schools inFrance owing to the high quality of its

academic staff (over 100 permanent lecturers fromFrance and abroad) and its privileged relationshipwith professionals that the school has beendeveloping since it was established in 1906. EdhecBusiness School has decided to draw on itsextensive knowledge of the professionalenvironment and has therefore concentrated itsresearch on themes that satisfy the needs ofprofessionals.

Edhec is one of the few business schools in Europeto have received the triple internationalaccreditation: AACSB (US-Global), Equis(Europe-Global) and AMBA (UK-Global).

Edhec pursues an active research policy in the fieldof finance. Its “Risk and Asset ManagementResearch Centre” carries out numerous researchprogrammes in the areas of asset allocation and riskmanagement in both the traditional and alternativeinvestment universes.

The Edhec Risk and Asset ManagementResearch Centre structures all of its research

work around asset allocation. This issuecorresponds to a genuine expectation from themarket. On the one hand, the prevailing stockmarket situation in recent years has shown thelimitations of active management based solely onstock picking as a source of performance. On theother, the appearance of new asset classes (hedgefunds, private equity), with risk profiles that arevery different from those of the traditionalinvestment universe, constitutes a new opportunityin both conceptual and operational terms. Thisstrategic choice is applied to all of the centre'sresearch programmes, whether they involveproposing new methods of strategic allocation,which integrate the alternative class; measuring theperformance of funds while taking the tacticalallocation dimension of the alphas into account;taking extreme risks into account in the allocation;or studying the usefulness of derivatives inconstructing the portfolio.

Percent of variation between funds

Source: Edhec (2002) and Ibbotson, Kaplan (2000)

EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE

40.0%

45.5%

11.0%3.5%

Strategic Asset Allocation

Tactical Asset Allocation

Stock Picking

Fees

The choice of asset allocation

20 Edhec Risk and Asset Management Research Centre

In a desire to ensure that the research it carries outis truly applicable in practice, Edhec has

implemented a dual validation system for the workof the Risk and Asset Management ResearchCentre. All research work must be part of a researchprogramme, the relevance and goals of which havebeen validated from both an academic and abusiness viewpoint by the centre's advisory board.

This board is made up of both internationallyrecognised researchers and the centre's businesspartners. The management of the researchprogrammes respects a rigorous validation process,which guarantees both the scientific quality and theoperational usefulness of the programmes.

To date, the centre has implemented six researchprogrammes:

Multi-style/multi-class allocation

This research programme has received the supportof Misys Asset Management Systems, SG AssetManagement and FIMAT. The research carried outfocuses on the benefits, risks and integrationmethods of the alternative class in asset allocation.From that perspective, Edhec is making asignificant contribution to the research conducted inthe area of multi-style/multiclass portfolioconstruction.

Performance and style analysis

The scientific goal of the research is to adapt theportfolio performance and style analysis modelsand methods to tactical allocation. The results of theresearch carried out by Edhec thereby allowportfolio alphas to be measured not only for stockpicking but also for style timing. This programme ispart of a business partnership with the firmEuroPerformance (part of the Fininfo group).

Indices and benchmarking

Edhec carries out analyses of the quality of indicesand the criteria for choosing indices for institutionalinvestors. Edhec also proposes an originalproprietary style index construction methodologyfor both the traditional and alternative universes.These indices are intended to be a response to thecritiques relating to the lack of representativity ofthe style indices that are available on the market.Edhec was the first to launch composite hedge fundstrategy indices as early as 2003. The indices andbenchmarking research programme is supported byAF2I, Euronext, BGI, BNP Paribas AssetManagement and UBS Global Asset Management.

Asset allocation and extreme risks

This research programme relates to a significantconcern for institutional investors and theirmanagers – that of minimising extreme risks. Itnotably involves adapting the current tools formeasuring extreme risks (VaR) and constructingportfolios (stochastic check) to the issue of thelong-term allocation of pension funds. Thisprogramme has been designed in co-operation withInria's Omega laboratory. This research programmealso intends to cover other potential sources ofextreme risks such as liquidity and operations. Theobjective is to allow for better measurement andmodelling of such risks in order to take them intoconsideration as part of the portfolio allocationprocess.

Asset allocation and derivativeinstruments

This research programme focuses on the usefulnessof employing derivative instruments in the area ofportfolio construction, whether it involvesimplementing active portfolio allocation orreplicating indices. "Passive" replication of"active" hedge fund indices through portfolios ofderivative instruments is a key area in the researchcarried out by Edhec. This programme is supportedby Eurex and Lyxor.

ALM and asset management

This programme concentrates on the application ofrecent research in the area of asset liabilitymanagement for pension plans and insurancecompanies. The research centre is working on theidea that improving asset management techniquesand particularly strategic allocation techniques hasa positive impact on the performance of Asset-Liability Management programmes. Theprogramme includes research on the benefits ofalternative investments, such as hedge funds, inlong-term portfolio management. Particularattention is given to the institutional context ofALM and notably the integration of the impact ofthe IFRS standards and the Solvency II directiveproject.

An applied research approach

21Edhec Risk and Asset Management Research Centre

In a desire to guarantee that its research work isboth relevant and operational, the Edhec Risk

and Asset Management Research Centre has set upan advisory board chaired by Mr. Jean-FrançoisLepetit, associate professor with Edhec and formerpresident of the French regulatory authority, theCOB (Commission des Opérations de Bourse).

The board is made up of around twenty members,chosen according to their experience and theirexpertise in the financial domain and, morespecifically, in asset management. The functions ofthe board are, on the one hand, to validate theobjectives of the research programmes proposed bythe management of the centre and, on the other, toevaluate the results of the research with a view tothe impact that they could have on the practices ofthe asset management industry.

The board will also be called on to give its opinionon the content of the projects that Edhec developsfrom the research of its asset management researchcentre (initial training, executive training, etc.).

The board meets on a yearly basis during plenarysessions that allow current and future researchcentre developments to be reviewed. The boardchairman may also, on certain subjects, form ad-hoc working groups that would be in charge ofpreparing or studying in greater detail themes thathave been or will be brought up in the plenarysession.

In order to facilitate the dialogue between theacademic and business worlds, the centre has

recently undertaken four major initiatives:

Opening of a web site that is entirely devoted to theactivity of international research into assetmanagement. www.edhec-risk.com is aimed at apublic of professionals who wish to benefit fromEdhec's analyses and expertise in the field ofapplied portfolio management research such asdetailed summaries, from a business perspective, ofthe latest academic research on risk and assetallocation as well as the latest industry newsassessed in the light of the results of the Edhecresearch programme. www.edhec-risk.com is alsothe official site for the Edhec Indices.

Launch of Edhec-Risk Advisory, the consultingarm of the research centre focusing on riskmanagement issues within the buy-side industry,and offering a wide range of services aimed atsupporting fund managers and their serviceproviders in the fields of operational risk, bestexecution, structured products, alternativeinvestment due diligence and risk managementsystem implementation.

Launch of Edhec Investment Research, in orderto support institutional investors and assetmanagers in implementing the results of the EdhecRisk and Asset Management Research Centre’sresearch. Edhec Investment Research proposesasset allocation services in the context of a “core-satellite” approach encompassing alternativeinvestments.

Launch of Edhec Alternative InvestmentEducation, which is the exclusive official CAIAassociation course provider for Europe.

The aim of the Edhec Risk and AssetManagement Research Centre is to become the

leading European centre of research into assetmanagement in the coming years. To that end,Edhec has invested significantly to give the centrean international research team made up of bothprofessors and permanent researchers, with whomprofessionals are affiliated in the capacity ofresearch associates.

To date, the Edhec Risk and Asset ManagementResearch Centre has more than 28 members: 15permanent members and 13 associates that areoperating in firms that are reputed for theirproficiency in asset management.

This team is managed by Professor Noël Amenc,who has considerable experience in assetmanagement as both an academic and aprofessional.

Edhec Risk and AssetManagement Advisory Board

Research for business

The team

22 Edhec Risk and Asset Management Research Centre

http://www.edhec-risk.com/AIeducation

http://www.edhec-risk.com/AIeducation

http://www.edhec-risk.com/Edhec%20Investment%20Research

http://www.edhec-risk.com/advisory

http://www.edhec-risk.com/


Edhec Risk and AssetManagement Research Centre

393-400 Promenade des AnglaisBP 3116

06202 Nice Cedex 3France

Tel. +33 (0)4 93 18 78 24Fax +33 (0)4 93 18 78 40

[email protected]


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hedge fund industry: is there a capacity effect?

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