The Role of Hedge Funds in In-stitutional Portfolios: Part III Contributed by Hilary Till Principal, Premia Capital Management, LLC www.premiacap.com PRMIA Member Since February 2002 In previous articles we have discussed how the hedge fund industry and institutional fund man-agement arise from different intellectual tradi-tions. We had noted that one possible concep-tual framework for incorporating hedge funds into institutional portfolios is to use hedge funds as substitutes for traditional asset alloca-tions. This article will cover two other frameworks for institutional hedge fund investing: as un-conventional betas and as alpha generators. There have been a number of creative articles attempting to extend the Sharpe-style returns-based analysis to hedge funds. In Sharpe (1992), the author discusses how to model mu-tual fund portfolios as a mix of a limited set of investment styles, and this methodology is widely used by mutual funds and their inves-tors. In a Sharpe style analysis, for example, an equity “growth fund” could be 70% large growth, 25% large value, and 5% small growth. Fung and Hsieh (1997) note that: The elegance of Sharpe’s intuition was demon-strated empirically by showing that only a lim-ited number of major asset classes was re-quired to successfully replicate the perform-ance of an extensive universe of U.S. mutual funds. There is not yet a consensus on how to apply the style factor approach to hedge funds. Four possible approaches to consider in coming up

with a limited number of factors to explain hedge fund performance are as follows: • Create multi-factor models, which include

such terms as changes in credit premia and changes in equity option implied volatility as well as asset-based style factors;

• Use only asset-based style factors; • Extract a small set of statistical styles from

manager data; and • Use the returns on existing hedge fund

style indices themselves as the factors. Figure 1 (next page) summarizes the hedge fund styles for which the asset-based style fac-tor approach has been successful so far in ex-plaining returns. As noted previously, there is not yet a consen-sus on which factor approach to use. The larger point to make, though, is that there is not even a consensus on whether the factor approach is appropriate for hedge fund investments. The next section of this article will adopt the point-of-view of emphasizing the pure alpha aspects of hedge fund investing. Morgan Stanley (2001) emphasizes the “alpha advantage” of hedge fund managers. They write that: Our research has shown that a significant pro-portion of the total return to hedge funds in the past has been alpha, in contrast with a small negative total alpha for mutual funds … They hypothesize that: One possible explanation for an “alpha advan-tage” … is that … [the active managers] can

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Institutions & Hedge Funds; Risk Management’s Dark Side; Lower GSE Valuations; Nerds or Serious Risk Professionals

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Featured Jobs 3

PRM Holder Survey Highlights Focus for Risk Profession in 2005

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Top PRM Candidates 4

PRMIA Opens Chap-ter in UAE

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PRMIA Munich Pro-file

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• Annual Campaign underway. Member contributions support local chapter activi-ties and online re-sources

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• Membership set to break 20,000

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forecast expected returns better than others. This means a significant ability to exploit market inefficiencies to outperform their benchmarks, pre-sumably by virtue of skill, knowledge, and insight. If hedge funds are exploiting market inefficiencies, this means that other investors are sup-plying those ineffi-ciencies. This means that, unfor-tunately, we can’t all profit from ex-ploiting inefficien-cies. Therefore, there is a natural cap on the potential size of the hedge fu nd ind us t r y (assuming that hedge funds are indeed exploiting inefficiencies rather than taking in risk premiums.) Under this frame-work we can esti-mate how large the hedge fund industry could become based on the following three factors:

The maximum tolerance of the average investor for sup-plying inefficiencies;

The required return targets of hedge fund investors; and The size of the global capital markets.

As an example, say the average investor can tolerate up to –0.50% of inefficiencies in their traditional investments before competitive (or regulatory) forces will step in to keep this num-ber from getting larger. Simultaneously, let’s say hedge fund investors demand at least 10% in excess returns before commit-ting their money to hedge funds. One might expect that hedge fund investors would require premium returns because these investment vehicles tend to be quite opaque and illiquid. Using these two assumptions, one could plausibly arrive at the size of the hedge fund industry becoming $2.75 trillion (= $55 trillion * 0.50% / 10%), if we estimate the size of the global capital markets as being $55 trillion. The next article in this series will cover three other frameworks for institutional hedge fund investing: (1) as traditional factor exposures with additional returns from market segmentation

and liquidity premia, (2) as total-return vehicles accessed through fund-of-hedge funds, and (3) as unstable factor expo-sures.

Fung, William and David Hsieh, “Empirical Charac-teristics of Dynamic Trading Strategies: The Case of Hedge Funds,” Review of Financial Studies, Summer 1997, pp. 275-302. Fung, William and David Hsieh, “The Risk in Hedge Fund Strategies: Alterna-tive Alphas and Al-ternative Betas,” The New Generation of Risk Management for Hedge Funds and Private Equity In-vestments, Euro-money, London, 2003. Morgan Stanley Quantitative Strate-gies, “Hedge Funds Strategy and Portfo-lio Insights,” De-

cember 2001. Sharpe, William, “Asset Allocation: Management Style and Performance Measurement,” Journal of Portfolio Management, Winter 1992, pp. 7-19. The Dark Side of Risk Management: How People Frame Decisions in Financial Markets Contributed by Luca Celati Chairman, Chief Investment and Risk Officer, Abraxas Capital Management PRMIA Member Since October 2002

As many – if not most – practitioners in finance have heard of Behavioural Finance (BF), the notion that people are not the automatons depicted by conventional economics and efficient market hypothesis (EMH) may hardly strike as new. Nor is the topic of human error, which has been studied in several excel-lent publications on man-made disasters.

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If you’re looking to hire, you can post your openings for free and can even use the search utility to find a certified PRM to meet your needs.

The PRMIA Jobs Board is a free resource to PRMIA members. Over 25,000 job searches take place each month on the board and this month, over 400 Jobs in fourteen countries are listed.

Each month we randomly feature some of the latest postings, but be sure to search the entire database to see what is available. All job listings can be found by clicking Jobs Board.

Over 400 Jobs Posted On the PRMIA Jobs Board: 150 New This Month

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The Dark Side of Risk Management: How People Frame Decisions in Financial Markets

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With its emphasis on risk-return optimization, modern risk management is an offspring of Modern Finance Theory (MFT) and its array of assumptions on human behaviour. As such – and partly due to the predominant quantitative culture with which it is commonly associated - it has to date escaped the challenge from BF. The Dark Side of Risk Management, pub-lished FT-Prentice Hall in November, challenges mainstream thinking by look-ing at the practical implications of Be-havioural Finance findings for Risk Man-agers. The book asks three basic ques-tions: BF studies tend to look at the impact of

their findings in markets. What hap-pens inside organizations and how do the poorly-understood human biases affect risk decisions?

Leaving aside the debates in academia, what should a trader, his boss and his risk manager be aware of in terms of each other’s psychological inclinations and their own?

As the risk management industry has evolved in variety and depth of tools, what can be done to include these biases – and not just their effects, the losses that they may originate – into the standard risk manager’s toolkit?

As any reader has to find his or her own answers on his own, the book is predominantly descriptive rather than prescriptive. It is organized in three sections: The Theory part shows how biases often start from the limita-

tions in people’s information processing abilities. The overload resulting from the Information Age only com-

pounds the problem. Thus, people use heuristics, a variety of shortcuts and rules-of-thumb that save time and simplify information. People do not have problems within, they also have issues when others are involved in decision-making. A thorough review of groupthink and some hints of Game-theoretic models concludes the section.

The Practice part shows a series of portfolio allocation and financial decision examples to illustrate how biases and visual framing work in practice. A review follows with the behav-iour of some of the key actors in the daily risk and trading drama. Thereafter, two chapters document the disastrous effects of biases in a series of risk disasters both in finance and in the real world, including Chernobyl, the Space Shuttle and the Titanic. The Going Forward section outlines what a reader can do about the biases illustrated ear-lier in the book. This is where one understands the connection between standard BF and the need for introspection and meditation of which top traders and managers are aware. As is the case with most BF-related literature,

disbelievers and sceptics will have their objections and indeed the author has devoted an entire chapter to them. Rather then claiming to have found the absolute truth, the Dark Side of Risk Management is more about providing tools for self-understanding and for dismantling the many false truths that marketing has created in the risk management arena. While understandable from a marketing point of view, it is odd that most Operational Risk and em-

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Lecturer at City University Business School and at London Guildhall University. Dr. Giannopoulos has worked for the Lon-don Clearing House where he led projects on measuring and analyzing the market risk of financial futures and options across all derivative exchanges in London. He has also served in advi-sory roles to RealKredit Danmark, Credit Suisse, Buchanan Partners, the Private Bank and Trust Company and Bank Pekao, among others. Dr. Giannopoulos has his PhD from London Guildhall Univer-sity, his MA in Banking and Finance from the University of Wales, Bangor and a Doctor Laureate in Economics and Bank-ing from Siena, Italy. Tan You Leong and Francois Bourdon to Receive PRM Candidate of the Year Awards at Ceremony During December, special awards ceremonies will be held in Singapore and Montreal, respectively, for 2004 PRM Candidate of the Year Award Winners, Tan You Leong and Francois

Bourdon. PRMIA’s Regional Directors in these chapters will be awarding the prestigious trophy during a local chapter meeting, which is expected to be attended by financial press and distinguished guests.

Survey of PRM Holders Looks at Issues Warrant-ing Our Attention in the Coming Year A survey of certified Professional Risk Managers that was con-ducted during October and November of this year suggested that the areas most warranting their attention and preparation in the coming year are, in order: Basel II, Integration of Risk Measures, Derivatives, Corporate Governance, RAROC and Capital Allocation, Regulatory Changes (Ex Basel II and CAD), Corporate Credit Risk and Liquidity Risk. At the bottom of the chart were SARS, Bird Flu and Other non-Terror Bio-logical Issues. The survey also asked what PRM’s thought of the state of the risk profession. Two-thirds described it as “Growing with a great deal of potential for continued growth”; one-quarter said that risk management is at a cross-roads, deciding whether it will be a control or strategic function; 8% felt it was growing, but nearing a peak and 1% thought it was headed in the wrong direction...fast. The number of risk professionals holding or pursuing the PRM designation has grown 180% over the past year and the exam program continues to gain accolades for its structure and pre-dictive power which distinguishes it from other risk manager certification programs. PRMIA Opens New Chapter in the UAE

The Professional Risk Managers’ International Association (PRMIA) is pleased to announce that Dr. Kostas Giannopoulos has been named the first Regional Director for PRMIA UAE, the 53rd chapter in the PRMIA network. Dr. Giannopoulos currently serves as an Assistant Professor in Financial Management at UAE University. Prior to his position at UAE University, he held academic positions as a Senior Lec-turer in Finance at the University of Westminster, a Visiting

Other PRMIA News and Items of Interest

Top Scores in Fourth Quarter 2004 (to-date) Exam I - Finance Theory, Financial Instruments and Markets Rajneesh Motay, Alabama, US Exam II - Mathematical Foundations of Risk Measurement Anand Balasubramanian, Bangalore, India

Exam III - Financial Risk Management Practices

Bisma Dewabrata, Alabama, US Exam IV - Case Studies, Standards of Best Practice, Conduct and Ethics, PRMIA Governance Karolina Klimpatyuk, Alberta, Canada

Congratulations to the Top PRM Candidates

Francois Bourdon Tan You Leong

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Systems & Controls • The first priority for the new agency, perhaps even explic-

itly stated in the proposed legislation, will be to review and certify that Fannie, Freddie and the rest have the internal systems and controls in place to manage risk and be "fully transparent to the marketplace and the regulator," to quote one player involved in shaping the proposal. As of now, the lucky officers and directors of GSEs will either be made subject to governance and audit requirements of Sarbanes-Oxley or a new statute that looks just like it.

Lower Returns, Lower Valuation • More stringent risk management, higher capital levels and

enhanced internal controls at Fannie will result in "significantly lower returns" to private investors than has been the case in past years. Fannie reported a 26% ROE in 2003, but commercial banks averaged half that rate. Due to their market position, Fannie and Freddie also are able to charge lenders, particularly small banks, excessively high "guarantee fees" in relation to the credit losses of the mort-gages they originate.

• The objective of the Administration proposal will very

clearly be to reduce the possibility of a "systemic event" generated by one of the GSEs by requiring increased capital and decreased risk-taking. In the view of one player in-volved in the actual drafting, the objective is to ensure that the GSEs focus on their legal mandate to support affordable housing and nothing else.

• "We are not going to see FNM playing in aircraft financing

or other non-core areas," one of the principals told us last week. The same official conceded that Fannie's stock will take a serious hit when the market realizes the full scope of the Administration proposal, but says the pain is necessary to achieve long-term stability.

Accounting • In terms of accounting adjustments, the best guess at this

stage is that Fannie must restate its financials to accommo-date several inaccuracies in past financial statements. This includes a roughly $8 billion cash charge to accelerate rec-ognition of realized losses on hedging activities and a lar-ger, double digit non-cash charge to recognize valuation adjustments for mark-to-market on "imperfect" hedges.

• While the latter number is probably going to be in the $20-

30 billion range, the market will likely treat this event like all non-cash charges and work off of the pro-forma state-ment rather than GAAP.

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pirical evidence in other fields (such as civil aviation) attribute about 70-80% of problems and losses to human error but then track mostly their effects, namely the losses that they determine. In spite of all the controversy surrounding psychometric tests, the book introduces their use in the Risk Management context to illustrate the possibility of measuring the correlation between personality features and losses. Some financial-services regula-tors are indeed evaluating the possibility of including psycho-metric tests as a means of quantifying and managing operational risk. If you are a manager, you are ignoring the lack of diversifi-cation amongst your team members and/or across the trading room at your own peril. This opportunity to understand and measure the real nature of human biases at their roots is where the book throws down the gauntlet by creating an extremely ambitious new angle in risk management. Luca Celati is the Author of The Dark Side of Risk Management: How People Frame Decisions in Financial Markets. Prentice Hall available for pre-order at http://www.pearsoned.co.uk/Bookshop/detail.asp?item=100000000031942

New Proposal Implies Lower Valuations for Fannie Mae and Other U.S. GSEs Contributed by Christopher Whalen PRMIA Member Since January 2004 http://institutionalriskanalytics.com/index.html We took a trip to Washington last week to get a sense for the Bush Administration's priorities in the area of financial services, particularly now that President Bush is playing for the history books. Even with the excitement of the election win, on the morning of November 3rd we found the wheels turning hard at 1500 Pennsylvania Avenue as members of the Bush Treasury worked to get new legislative proposals for reforming Social Security and the GSEs ready for transmittal to Congress. Regarding the legislative proposal for GSEs, here's a summary of the opinions and views that we gathered in a series of meet-ings with members of the Administration, Congress and the pol-icy community last week: New Regulator • The Administration proposal will combine and strengthen

the two existing regulators of the GSEs, including Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE) and the 12 federal home loan banks. The goal is to give the new agency sufficient authority to regulate the GSEs and, equally important, attract new talent of sufficient caliber to staff the agency. GSE regulator OFHEO suffers from a sig-nificant disadvantage in terms of recruitment vis-à-vis the other bank regulators, thus the proposal seeks to make the new regulator co-equal with the FDIC, OCC, etc. Good luck.

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Conflict of Visions: Private Company or Public Enterprise? None of these legislative proposals are radical changes from the status quo in terms of the current business model of Fannie par-ticularly and the GSEs generally. This raises a problem, how-ever, because as governmental oversight of Fannie grows more comprehensive, the role of the company's managers and direc-tors is going to be increasingly circumscribed. Or to put it an-other way, if the Treasury is Fannie's ultimate supervisor, then why does the company need a board of directors or even private shareholders? One White House official tasked with moving the GSE legisla-tion through Congress says that the ultimate goal is too ensure that "we never read about Fannie in the newspaper again regard-ing governance or accounting." More than a few people we spoke with last week felt that the senior management and board of Fannie must be changed, but under the current legal and regu-latory cloud, including several pending shareholder lawsuits, who would want such a job? Since Fannie pretends to be a private enterprise, albeit one that serves a public policy role, the officers and directors of Fannie have no safe harbor such as sovereign immunity to shield them from civil prosecution. Thus even as the SEC drags its feet with respect to its inquiry regarding Fannie's internal controls and governance structures, in coming weeks and months, the trial lawyers will be conducting extensive discovery. Don't forget that it is SOP for the DOJ to exploit information unearthed dur-ing civil litigation before bringing criminal indictments. Several class action lawsuits have already been filed against Fannie for allegedly misrepresenting company information. The lawsuits cite the September 22, 2004 study by Fannie regulator OFHEO that charge the company with manipulating earnings reports. Fannie shares fell 10.3 percent following the study to a low of $66.50, but have since bounced back over $70. But if the Bush Treasury gets its way and imposes 1) new restrictions on Fannie's growth and 2) higher capital levels, then the valuation metrics currently used by the Street will need to be extensively revised.

Nerd in the Corner or Serious Risk Profes-sional : A Survey of Fund Managers Contributed by Jim Trotter Principal, Investit PRMIA Member Since January 2004 http://www.investit.com The 2004 Investit Performance and Risk Survey found that only 26% of fund managers wouldn’t want to run money without the back-up of risk professionals. What the other 74% of fund man-agers are doing was one of the risk concerns which emerged

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• No one we spoke to last week has any clear idea on how to resolve the valuation of complex financial instruments, an issue specifically raised by the Fannie situation that applies to the entire universe of SEC filers. While the Administra-tion may move ahead with its legislative proposal shortly, the uncertainty regarding Fannie's current financial position continues to be a major concern within the Bush Admini-stration.

• Part of the issue here is and will be which model to use to

value Fannie's hedging positions. Fed Governor Susan Schmidt Bies told the SIA meeting in Boca Raton last week: "Given the myriad of complex financial instruments that currently exist and that are constantly being created, developing verifiable and auditable fair value estimates is a major concern. And because fair value models are forward looking, an auditor has an additional challenge: determining what is the normal variability in expectations that surrounds any forecast and what is earnings manipulation."

• Most observers seem to agree that Fannie will be making at

least one set of adjustments to past earnings and financial statements. One senior commercial banker in New York opines that until the investigations of Fannie Mae by the three other audit firms are complete, "the auditors are not going to sign anything." With a criminal inquiry by the DOJ also underway, we hear that it could be many months before auditor KPMG is willing to sign-off on Fannie's revised financial statements.

• As a result, investors, the Congress and other interested

parties may not have access to certified restated financials for Fannie for months to come. Until these new financial statements are disclosed, Fannie's current valuation is at best a matter of conjecture.

Consolidation & Competition • In terms of competition among the GSEs, the Administra-

tion does not have any intention of changing the current legal authority or permitted activities for the various enti-ties. The internal view of the FHLBs is that they will con-tinue to provide funding to the member banks, but are al-lowed to expand and even merge if they meet regulatory standards.

• To the extent that minimum capital levels and other con-

temporary risk measures are applied to the FHLBs, the practice of lending many times an FHLB's capital to one bank - as in the case of troubled Washington Mutual (NYSE:WM) - may be forced to an end.

New Proposals Imply Lower Valuations for Fannie Mae and Other U.S. GSE’s

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tems. Nearly two thirds of participants are using 3 or more ex-ante tools. Barra dominates the results again this year with over 60% of performance teams using it as their primary system. Style Research and Northfield play important secondary roles

for nearly 20% of participants respec-tively, with RiskMet-rics playing a major role for firms with hedge funds. Con-versely, 90% of par-ticipants make use of 2 or less tools to meet their ex-post require-ments. Roughly half of these use their main performance engine. Other themes that emerged from the survey highlighted some key issues, in-cluding: internal sys-tems for performance measurement and

attribution still dominate in the total solution; excel remains the key distribution channel for attribution analytics; fixed income attribution continues to be a key value added requirement for teams to tackle; and significant feedback on the repetitive nature of performance and risk work and excessive working hours. Investit’s second Performance Measurement and Risk Manage-ment Survey 2004 published in early November questions 21 heads of performance measurement representing firms with total assets under management of £1,010bn. The survey focuses on the trends and developments in team responsibilities, systems, risk measurement, trends, responsibilities and remuneration, GIPS and vendors. The Investit Performance and Risk Survey is conducted by Jim Trotter. If you would like to obtain the report, ask any questions, or participate in future surveys Jim can be contacted on +44 (0)20 7920 9007 or at jim.trotter@investit.com.

from the survey this year, highlighting the current state-of-play within performance and risk teams, says Jim Trotter, Principal of Performance and Risk at Investit. The majority of per-formance and risk teams have risk measurement re-sponsibilities but of those only a third look after further risk management issues. Interestingly, although most par-ticipants feel that their risk responsi-bilities will grow over the coming years, only half of the participants cur-rently feel that port-folio managers view the work undertaken by risk professionals as useful and merely a quarter feel that the managers would not want to run money without this back up. The view of risk professionals by portfolio managers The purpose of investment risk management differs greatly across the different investment teams with no single dominating factor. Some teams view this as part of the investment process and as an aid to portfolio construction, whilst others view it as a monitoring tool for the CIO or something that they have to be seen to be doing for the clients’ and consultants’ benefit. Risk is only considered essential by institutional clients whereas retail and private clients are purely concerned that someone within the organisation is looking at risk and that performance objectives are being met. Only a quarter of the participants sur-veyed set formal risk budgets for their portfolios; the large ma-jority either relating performance objectives to risk levels from assumed information ratios or through broad assumption based on expected risk numbers for different mandates. One of the problems facing performance and risk teams is that ex-ante risk models rely greatly on historic volatility and corre-lation with most fund managers believing that these models un-derestimate tracking error. Consequently performance and risk teams carry out regular back testing of the models. The survey also highlighted that instrument and security coverage continue to be a major challenge for teams dealing with fixed income models. There is still a trend for multiple ex-ante and ex-post risk sys-

PRMIA receives no remuneration for articles that ap-pear in the Members Update. Any opinions expressed, or statements made in the articles above are those of the author and are not necessarily those of PRMIA. Mem-bers interested in contributing material to the PRMIA Members Update should contact resources@prmia.org.

47%

37%

26%

11%

5%

0% 100%

They sometimes come up with somethinguseful

I guess we have to have this stuff

Wouldn't want to run money without thisback-up

They can't tell me anything about myportfo lio

Nerd in the corner

Source: Investit 2004 Performance and Risk Survey

Fund Managers on Risk Managers: Nerd in the Corner or Serious Risk Professional?

Regional Director

Dr. Dominik Dersch, HypoVereinsbank

Steering Committee

Michael Thiergen, HypoVereins-bank Rudi Zagst, Technical University of Munich

Michael Ege, Münchner Rück

Statistics Membership: 455 Chapter Formed: June, 2004 Members’ Areas of Interest:

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16 December—Integrated Asset-Liability Analysis. Speaker: Dr. Gerhard Scheuenstuhl, Managing Director risklab germany GmbH.

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VaR 45.5% Credit 43.1% Derivatives 43.1% Basel II 41.8% Asset/Liability Management 38.7% RAROC / RAPM 36.9% Traditional Asset Mgmt 34.1% Financial Engineering 33.2% Financial 32.5% Consulting 29.5%