“A bear market, coupled with a low interest-rate environment,” says Bernice Miedzinski, a consultant at York Hedge Fund Strategies in Toronto, “highlights the need to consider alternative investments for greater diversification.” Alternative investments, she suggests, can be treated as risk reducers or return enhancers.
Risk reducers or return enhancers? That’s a new way of thinking, with a new language for investors. Pension trustees venturing into alternatives will have to be prepared to look at each investment on its own merits, while searching for an appropriate benchmark, be it a peer group or some percentage return over T-bills. They will have to understand how alternative managers achieve those returns, and what risks they are incurring along the way.
EXPANDING THE INVESTMENT LEXICON
Talking about risk reducers and return enhancers means reconsidering precepts that have guided institutional money management for the past 30 years. As they were given freedom to diversify into equities, pension funds sought to earn at least as much as, and maybe even a little bit more, than what was on offer in the markets.
Beta is often used as a synonym for what the markets offer, or rather, what the market indexes track. If an investor earns the market return, they receive the beta. By contrast, if active managers are able to beat those indexes, they add value, or alpha. Alpha has been conventionally defined as the “information ratio.” A manager who could add returns above the market index was thought to have superior “information” or insight, and the information ratio quantified their skill.
There are many ways to define alpha: excess return over a benchmark is one, the Sharpe ratio(a variant of the information ratio)is another. Increasingly, the Sharpe ratio is at the centre of the alternative universe, since it quantifies the degree of manager outperformance over risk-free assets: what an investor would get by holding safe investments such as T-bills.
Why does the risk-free rate matter? A high information ratio is of little value if the overall benchmark is below water. Although the manager may beat the index, the returns may not be good enough to fund plan obligations. What matters is an absolute return: one that produces more than just parking assets in the money markets would, so the extra risk is rewarded with a positive return.
Miedzinski argues—and she’s not the only one—that investors have to consider downside protection. Using the risk-reducer/return-enhancer model, Miedzinski qualifies the risk and return characteristics of different investments. She puts domestic equity investments just above the middle rung of a ladder of investment opportunities. To get more return, there’s international equities and then private equity. To incur less risk, there are, to start at the bottom rung, cash, opportunistic fixed income strategies, deflation hedges(nominal bonds), inflation hedges(real return bonds and real estate)and then, a rung below full-blown equity exposure, absolute return strategies—basically hedge funds.
Are all of these rungs separate asset classes? Wendy Brodkin, president of Goodman Institutional Investments in Toronto, says no. Alternatives often involve investing in the same asset class, but using a greater array of techniques. To name two: hedge funds can short an overvalued stock, and so play both sides of the market—as it’s going up and as it’s coming down. Private equity funds are part of the equity class. Still, they capture a return in exchange for illiquidity—they’re not bought and sold everyday on an exchange, and may take years before they show a profit.
WHY THERE’S NO “THAT 90’S SHOW”
These two examples illustrate a broader theme in institutional investing. In many respects, alternative asset managers seek to tap risks—and earn premiums—that are quite different from the risks and expected returns of traditional markets. The alternative risk/reward trade-off is looking increasingly attractive to many institutional investors.
There are cogent reasons why the 1982 to 2000 bull market, in both stocks and bonds, will not repeat itself soon. The spectacular returns of the late 1990s must, some analysts argue, be matched by a significant correction that restores long-term patterns. That’s called reversion to the mean. Historically, stocks have averaged a price-earnings ratio of just under 15 times earnings. Today they’re around 20 times earnings: not as overpriced as 2000, but not cheap either.
From another perspective, the historical outperformance of stocks over bonds has been the product of a risk premium. Consider the Dow Jones Industrial Average. Of the 12 stocks it covered in 1896, only one, GE, is still there today. To offset the risk that a company might fail, stocks have historically had to yield more than bonds. The higher yield on stocks—the equity risk premium—is made up of three elements: dividend yields, dividend growth and finally, market appreciation, defined by the contraction or expansion of the P/E ratio.
Dividend yields are at all-time lows—1.7% as against the historical 5%—when stocks literally paid more than bonds, to justify holding a risky stock instead of a riskless bond. Dividend growth depends on company earnings, which cannot for long outpace GDP growth. Current projections of GDP growth are between 3% and 4%. The final element is the price/earnings ratio. No one expects it to mount the heights it did in the 1990s—50 times earnings— and many expect a significant contraction. At best the P/E ratio will remain stable.
As a result, the terms of the risk premium have changed. Market historians Burton Malkiel, a Princeton finance professor, and Jeremy Siegel, a Wharton finance professor, both cautioned, in recent Toronto appearances, that the equity risk premium is probably closer to 3% than the 4.7% historical figure. Others think it’s much lower, perhaps even zero.
Why does that matter? Assuming a 3% risk premium over a 4% to 4.5% long bond yield gives a return of 7% to 7.5% on stocks. Take a balanced portfolio and subtract inflation: the math is remorseless when it comes to matching plan assets and liabilities. That’s why some pension funds are looking at alternatives.
“I think the role of hedge funds,” Brodkin says, “is partly for the downside protection. The second reason is that people are wondering where they’re going to get returns from traditional markets. The third reason is to manage short-term volatility.”
To put it another way, alternatives are all about managing volatility, and trying to eke out a positive return despite broader market movements—a pressure all sorts of plans face.
“We wanted to get something that would give us a regular cash flow,” explains Nunavut Trust CEO Andrew Campbell in Ottawa. “Hedge funds seemed a vehicle that just might be able to do that.”
BEHIND THE LIABILITY CURVE
What would a portfolio diversified across traditional and alternative strategies look like? Yale University’s endowment, managed by Yale finance Ph.D. David Swenson, is a talking point. It has an allocation of 15% to U.S. equities and almost the same to foreign equities. There’s a 7.4% holding in fixed income, and 2.1% in cash. Of the rest of the portfolio, 25% is in absolute return strategies, 15% in private equity and 21% in real assets, such as timber, real estate, and oil and gas. That allocation has yielded a 16% return over the past decade.
That compares with the average university’s allocation of 40% to U.S. stocks, 24.5% to bonds and 13.8% to foreign equities in the traditional asset categories. For absolute returns, the average university allocates 13.4%, 5.1% to private equity and 3.1% to real assets.
Here are the comparable Canadian figures, drawn from BENEFITS CANADA’s annual review of pension plan allocations (see Top 100 Pension Funds, May 2004). Canadian equities took up 26.6% of the average portfolio, with 12.7% in U.S. equities and 14.4% in foreign equities, for a total equity component of 53.7%. Canadian bonds were 31.3% of the average portfolio, with minor allocations to global, high-yield and real-return bonds. In the real assets category, 3% was invested in real estate, plus 1.6% in mortgages. Hedge funds saw a 0.7% allocation, or 1% if managed futures are included. Private equity stood at 0.8%, or 1.3% if private placements are included. Timber, infrastructure, commodities, all are present in miniscule proportions, and would probably be accounted for in the private equity portion of the portfolio.
While the average Canadian plan investment in alternatives is quite low, that hardly captures what the bigger pension managers are doing. The Ontario Teachers’ Pension Plan in Toronto, through its Cadillac-Fairview subsidiary, is one of the biggest commercial landlords in the country. The Ontario Municipal Employees Retirement System(OMERS) is too, through Oxford Properties, while the Caisse de dépôt et placement du Québec in Montreal has its own real estate subsidiary, SITQ, as well as a share in Ivanhoe-Cambridge properties, a shopping mall owner.
Alternative investments aren’t limited to the office buildings where many Canadians work or the malls where they shop. In September, Ventures West closed the largest venture capital fund in Canadian history, a $250-million effort with investments from Teachers’, OMERS, BC Investment Management, University of Toronto Asset Management and the Caisse. For its part, the Canada Pension Plan Investment Board(CPPIB)now has $6.3 billion devoted to private equity, and wants to maintain a 10% allocation.
“Private equity fits well with our broadly diversified portfolio,” outgoing CPPIB president and CEO John MacNaughton said in July. “It is an attractive alternative to publicly traded stocks and has the potential to generate greater returns.”
Infrastructure investment is a growing category, too. Teachers’ and OMERS teamed up with Scottish and Southern Power to buy part of the national gas distribution grid in Britain. OMERS has stakes in the Confederation Bridge, the Windsor-Detroit Tunnel, and Ontario’s Bruce Power nuclear plant.
Just below the radar screen is timberlands. There is the potential for privatization of Canada’s Crown forests, suggests Brascan Financial’s COO George Myhal in Toronto and Brascan Asset Management is thinking of a fund based on its holdings in Brazil’s forests. In addition, the biggest player in the US$13-billion timberland industry, Hancock Timber Resource Group, is now a subsidiary of Manulife Financial.
Finally, there are hedge funds. Teachers’ has $4 billion in hedge fund assets, a program that began in 1996, while the Caisse, OMERS and some smaller funds, including Nunavut Trust and the Nova Scotia Association of Health Organizations, have opted for allocations in what is becoming a $1-trillion industry.
A note of caution is in order here: while many plans are seeking absolute returns to ensure they can meet their liabilities, not every alternative manager will provide them, year in and year out. Alternative managers may not track a benchmark, but economic trends can have an impact on the sectors they concentrate on. For example, a merger arbitrage fund is dependent on the volume of mergers; as they dry up, so do returns. Similarly, the year-over-year reports of private equity returns are largely a bookkeeping exercise. The actual returns only come when a private equity manager exits positions after a six or seven-year holding period and realizes a profit, says Robin Louis, president of Ventures West in Vancouver and chair of the Canadian Venture Capital Association.
HEDGE FUNDS
Hedge funds seem the most complex of alternative investments. Yet they mostly follow variations on a basic strategy. Market-neutral is a term trustees will encounter frequently, whether looking at a fund of hedge funds or an individual strategy. Market-neutral funds attempt to minimize beta exposure.
After all, if a plan already has beta—the stock market return—why duplicate it more expensively with a hedge fund? That’s the argument that Jim McGovern, managing director and CEO at Arrow Hedge Partners in Toronto and chair of the Canadian chapter of the Alternative Investment Managers Association, gives: why pay for beta when you can buy it through an indexed portfolio from State Street or Barclays Global Investors?
The simplest explanation of a market-neutral strategy comes from John Schmitz, managing director at SciVest in Toronto. Assuming a $100 contribution, SciVest would go long, or buy $100 in stocks. The fund would then sell $100 in stocks short. That money would then be parked in a brokerage account as collateral and invested in T-bills. In effect, the fund ends up with leverage of 100% or 2:1—$100 in fund assets commands $200 in capital—and three revenue sources: the long return, the short return and the T-bill interest. Those are the three elements of hedge funds: hedging, short-selling and leverage.
Where’s the alpha? There are three ways to make money in this strategy. In a rising market, if the shorted stock goes up less than the long position, the manager earns the spread. In a down market, if a long pick falls less than the short, again, the manager earns a premium. And if the market is flat, there’s still a chance to book a return, based on the fundamentals of the two stocks. This is an example of what are known as relative-value strategies. They try to block out broad market movements to earn an uncorrelated return on a specific stock position.
Relative-value strategies offer a template for understanding hedge fund investing. Since there is no common agreement on the specifics of each hedge fund strategy—alpha is supposed to be a measure of a manager’s skill at spotting opportunities rather than following a programmed routine—it might be better to look at how hedge funds can contribute to a traditional portfolio. Richard Spurgin, a member of the Centre for International Securities and Derivatives Markets at the University of Massachusetts in Amherst, suggests hedge funds can function in three ways: reduce volatility, enhance returns, or diversify a portfolio.
Opportunistic strategies, sometimes called global asset allocators, include funds classified as managed futures or short-sellers and global macro. They are risk reducers because they aren’t correlated with the equity and bond markets. Instead, they may be playing a particular economic trend, for example, emerging market debt, or currency valuations. In Spurgin’s classification, these managers are contrarians—they’re going against the grain and as a result, can provide downside protection if traditional markets take a tumble. Many made their reputation during the August/September 1998 market collapse.
Return enhancers, by contrast, include some opportunistic or “directional” strategies, such as long/short equity. These funds are not necessarily fully hedged: that is, their market exposure isn’t equally balanced between long and short positions. Some will be bullish, while others may be bearish. Their goal is to provide much of the market upside, while trimming downside losses. For Spurgin, these funds are taking advantage of “informational” inefficiencies: the managers have superior market insights over traditional benchmark trackers. In the Canadian universe of hedge fund managers, long/short managers are by far the most common.
Finally, portfolio diversifiers are broadly market-neutral strategies that attempt to tap economic inefficiencies— inefficiencies that arise because many investors won’t enter those markets or find them too complex. Another way to understand these strategies is that they are earning risk premiums—exotic betas, Brodkin calls them—for example, by providing “insurance” against a merger deal falling through by taking both sides of a trade—selling the acquisitor short and buying up the target company—or by supplying liquidity in a thinly-traded security.
These strategies are often called relative-value strategies because they try to profit from discrepancies in related securities: a pair of auto stocks for example with different profit outlooks, or convertible bonds that have embedded stock options. Such strategies shade off into another arenas where the profit opportunities come from specific corporate events, such as a bankruptcy. Again, Spurgin suggests, there’s a premium here that the manager earns simply by showing up for work.
A distressed manager can invest in junk bonds for example, and has an edge because many institutions are not allowed to hold non-investment grade bonds. Where institutions may have bailed out for 80 cents on the dollar, the distressed manager might buy for 20 cents, hoping for the debt to rise to 40 cents once the company is restructured.
With so many different strategies, how does a pension trustee approach hedge funds? While high-net-worth individuals may make commitments with individual hedge funds, many institutional funds either build their own fund of funds, or else buy a fund of funds. “The first thing we did was look at the marketplace and considered a fund of funds versus build your own,” says Rick McAloney, former CEO of the Nova Scotia Association of Health Organizations Pension Plan in Bedford, N.S. “We wanted something that would complement the rest of the pension plan balance sheet. So we decided to build our own. What we have is like a fund of funds, it’s just [that] we built all the pieces individually by allocations into individual hedge funds and a whole lot of different strategies.”
What about benchmarking returns? McAloney started with the London Interbank Offered Rate(LIBOR)plus 4%; he later switched to the S&P hedge fund benchmark.(McAloney has since become CEO of Keel Capital Management, which has an investment relationship with NSAHO.)Investable hedge fund benchmarks, provided by S&P and MSCI, among others, have been launched in the past two years and they are beginning to change the way investors—retail and institutional— look at hedge funds. But broadly, institutional investors are looking for T-bills or LIBOR plus 4% to 6% for their hedge-fund allocations. At the same time, they’re targeting volatility in the neighbourhood of that associated with long-term bonds.
REAL ESTATE
Every trustee understands real estate: it’s a tangible property that produces an income stream. Real estate has fixed- income-like properties—a regular yield from leases—but is nevertheless a private equity. To be sure, there are publicly traded Real Estate Investment Trusts(REITs). In Canada, they run the gamut from shopping malls, hotels and retirement residences, with some apartment exposure. But REITs are not the only vehicle for portfolio diversification.
Some pension funds, such as Teachers’ and OMERS, own real estate directly. For smaller pension plans, there are limited partnerships, generally invested in “core” commercial and industrial properties, with a seven to 10-year life. In this sector, investors are expecting to earn a yield like REITs, and perhaps some capital appreciation.
“In core real estate, 80% to 85% of your total return is going to come from rental income,” says David Mather, executive vice-president at Integrated Asset Management in Toronto, which has a number of real estate funds. What capital appreciation there is will arise by improvements the landlord makes to the property.
How does investing in a fund compare with REITs? “In the real estate market, we are seeing high-quality office properties trading at yields of 8% to 10%,” says Brascan’s Myhal. “But unlike income trusts, particularly business trusts, a lot of the properties that we operate are leased to A-rated or better tenants.” For core real estate, the quality of the property and the tenants are key considerations.
On the next level are real estate opportunity funds that, like venture capital funds, are more speculative. Less of the return derives from the income stream, and more from capitalizing on land acquisition and construction, repositioning or redeveloping of properties. Returns can be on the order of 16%, Mather suggests.
BRIDGES AND TREES
At the bottom of the real estate/hard assets continuum are timberlands and infrastructure: power plants, toll roads, electricity transmission grids and so on. They tend to be steady returners, like high-quality real estate.
On the infrastructure side, says Myhal, “We focus on hydro because it is the cheapest form of power to produce. Once you acquire a plant, your marginal cost of production is actually very, very low,” he explains. “Your revenues may rise or fall, depending on how much water there is, and they might also rise or fall depending on what the spot price of electricity is. But one thing you can be guaranteed of is that they will always be running and you will always be generating cash flow.”
Infrastructure involves a lockup—as much as 20 years. “Infrastructure, by its nature requires a very long view. It typically involves a lot of real estate and very substantial assets, whether it’s a dam, a power plant, a highway, a bridge,” says Mather. Still, “the risk of a catastrophic devaluation is relatively small.” Infrastructure offers stable, relatively predictable income and typically the revenues that are associated with them have a step-up provision,” to match inflation, he says.
Timberlands might be seen similarly: a long lockup but an inflation hedge. Mather likens timberlands to a bond with a permanent coupon, based on the annual rate of growth of the trees.
PRIVATE EQUITY
There are three broad categories of private equity funds: venture capital(VC), mezzanine and buyout. VC ranges from angel and early-stage investments(“pre-money”), where investors supply capital to get an idea off the ground with an established entrepreneur and into a production facility—by commercializing university research, for example—through to mid-stage(“pre-revenue”) companies that are bringing a product to market, to late-stage companies(“pre-profit”)that are marketing the product and have revenues and are ready to go public through listing on a stock exchange, or be shopped to an acquisitor looking for a strategic acquisition.
What’s specific to venture capital is an ongoing injection of funds into portfolio companies, usually in conjunction with a syndicate of investors. A first round of financing establishes a base price for the company, at cost, and it may involve less than $1 million or as much as $5 million. A second round, as the company moves from development to product marketing, sets a new valuation, based on what new investors ante up. That injection may increase the value of the company, or not. In that case, it’s a “downround,” and the managers may extract concessions—ratchet provisions—from the entrepreneur to protect their initial investment. It’s called “less money, more company” for the investors who succeed in reining in an exuberant entrepreneur. A third round might set the stage for a company to post revenue and even book a profit, as a preparation to a strategic buyout by a publicly listed company, or, alternatively a listing on a public exchange.
Mezzanine finance is a growing category—McKenna Gale, a Toronto-based firm just closed a $305-million fund, while Teachers’ and CDP Capital have just launched a $1-billion European mezzanine fund—and VCs are beginning to venture into this space. Mezzanine debt is a private loan—bridge financing—to an established company that offers a coupon return on the debt plus an equity kicker.
The third element of private equity consists of buyout companies. After some years in the doldrums, they have returned to prominence, in part because of the success of Teachers’ and Kohlberg Kravis Roberts in New York in buying the Yellow Pages division from BCE, and then spinning it off as an income trust. Teachers’ received the Canadian Venture Capital Associations’s “Deal of the Year” award, for turning a $300-million buyout of Yellow Pages into a $500-million gain.
That doesn’t prevent the head of Teachers’ Merchant Bank, Jim Leech, from levelling some pointed criticism of the Canadian venture capital industry. In June, he blasted the poor results from venture capital firms and private equity managers alike.
What’s common among all the forms of private equity is that they are targeting double digit returns such as 20% to 35%, in venture capital, around the same in the buyout space and in the middle teens for mezzanine ventures.
“In private equity you’re capturing inefficiencies,” says Mather. “You’re taking significant positions in a company, getting yourself on the board, drawing up a new business plan, adding value and exiting.”
Due diligence is the alternative investment opportunity set. While alternatives can offer an attractive risk/return profile, in theory, there are many questions trustees have to ask. Summed up: they concern liquidity, transparency and risk management.
For one thing, ownership structures and thus liquidity—the ability to get out—are quite different in the alternative space. Major pension funds have their own trading desks for direct investments. Medium-sized funds generally grant specific equity and bond mandates to different investment counselling firms. Smaller pension funds are likely to use a pooled fund structure.
By contrast, most alternative investment vehicles are organized as limited partnerships. In private equity, after the initial fund-raising, partnerships are closed to new investors. They may have a preordained lifespan, particularly in the private equity and real estate fields. Limited partners are generally locked in for seven to 10 years. Unlike the United States, there really isn’t a Canadian secondary market for partnership units, so unless an institution agrees to transfer holdings privately, they’re stuck.
With hedge funds, the structure is a little different. Many are open to continuous subscription. There is a lockup period, generally of three months. After that, partners have to give notice if they wish to liquidate their holdings. The industry norm is 90 days. Between giving notice, redemption and accounting, it could take a year for an investor to get out of a hedge fund.
Unlike equity mandates, full position transparency might not be available in a hedge fund—for fear of alerting competitors. Plus, seeing every position a hedge fund holds every day may not be particularly useful, unless a trustee wants to second-guess the strategy. What many hedge funds settle for is risk transparency—a daily update on what a fund might lose—99% or 95% of the time. It’s similar to what the big pension funds use in their Value-at-Risk analyses—what the most serious loss would be, for a day, a week or a month.
Transparency has another dimension: at the fund accounting level. In the U.S., a few funds have been caught in scandals where the manager did the valuation himself. Trustees should look for an independent administrator and custodian to ensure that assets are properly valued.
With private equity investments, transparency is harder, since investments aren’t valued day to day. The market value is set at each financing round: some may be uprounds and some maybe downrounds, where the investment value is lowered, but often with a clawback or “ratchet” provision. In those instances, the investor accepts a lower valuation, but also takes a greater ownership stake in the company, at the expense of the entrepreneur. The Canadian industry has recently published a set of valuation guidelines.
Because so much in the alternative sector depends on the manager’s skill, diversification is as crucial as it is for equities. The CPPIB, for example, has its private equity allocation invested in 46 limited partnerships, spread among 38 private equity firms. Teachers’ allocates its hedge fund investments among 120 managers.
That level of diversification is hard for a smaller pension fund to achieve. For that reason, the favoured vehicle is generally a fund of funds. Some managers will enter Canadian private equity funds directly, but, says Chris Caswell, investment director and risk manager of the VIA Rail pension fund in Montreal, the preferred route to participation in the U.S. private equity market is a fund of funds. There are also a few Canadian funds of private equity funds, led by the banks. Funds of funds are the preferred route for hedge fund investors.
Finally, there’s due diligence. “There’s a ton of paperwork associated with it,” says Nunavut Trust’s Campell. “I would think trustees might want to be pretty careful. If they’re going to try, just put a little bit of money in at first and see if they can live with it.”
There’s no getting around the paperwork, other investors report. Alternatives are more complicated than traditional investments, and what’s more, benchmarks don’t cover the dispersion of returns between good managers and bad ones. It’s best to consider them within an overall risk budget: what incremental return is there from assuming a higher risk or a different kind of risk.
For most alternative managers, the idea isn’t to shoot out the lights. It’s about risk-controlled returns. That’s why Campbell’s advice to trustees might be best of all: learn about the asset style or class, prepare for a lot of due diligence, and then assume the risk of investing in manageable portions.
Glossary of alternative investment terms Alpha: Alpha is considered a measure of a manager’s skill against a given benchmark. Alpha is an ideal. Isolating it is more complex. There’s always the possibility that the manager who earns a high alpha is actually tapping a beta that the market has not yet recognized. Consider the savvy developer who banked land and waited till urban sprawl caught up to him. Is that manager skill, or is it a function of the real estate market, or perhaps a little bit of both? Backfill bias: When a hedge fund is listed in an index, it may include gains prior to its listing—gains made when most investors weren’t aware of the fund. This backfill bias may overstate index returns. Beta: Conventionally, beta is the stock market return. In reality, beta is the measure of how much a given investment deviates from its benchmark. A beta of 1 indicates that an investment tracks the benchmark one-for-one. Drawdown: Hedge funds are evaluated not only on their ultimate returns, but how they achieve them. There can be months where a fund loses money: that’s its drawdown. There are two issues to consider. For the investor looking for consistent performance, how big was the drawdown, and how long did it last, from peak to trough to a new peak? Capital call: Private equity investors normally subscribe for a certain dollar investment amount. That money isn’t drawn on right away. First the fund manager has to find suitable investments. Investments in a given portfolio company are usually made in a series of financing rounds. When money is needed for those later rounds, investors receive a capital call. Capacity constraint: An alternative fund may have limited capacity: as it increases in size, it both loses the flexibility to make high-margin investments in small positions and must hire more staff. Equally, there can be limits to how much a strategy can sustain before it overwhelms an investment field. For example, from 1999 to 2000, private equity investment in the U.S. went from $40 billion to $100 billion, ensuring far too much money in search of good-quality opportunities. Similar constraints exist among other alternative strategies. Carried interest: In the private equity world, the performance fee is generally 20% of profits. Normally, the general partner won’t book those profits until they’ve entirely exited a holding, whether through an IPO or a buyout. Even so, there’s normally a hurdle rate: the fund must have earned some version of the current cash rate plus 4% or 5%, before they can take a profit. High-water mark: In the hedge fund universe, a manager will not take a profit unless the fund’s performance has exceeded a previous peak. With hedge funds, performance fees can be taken quarterly, according to market conditions. Hurdle rate: In both the private equity and the hedge fund universe, managers may not book a profit unless they’ve exceeded a certain minimum return, say T-bills plus 4%. Internal rate of return: The formula used for targeting private equity returns is the internal rate of return, essentially how much each investment made from the time it was invested(since capital is normally invested in stages). LIBOR: The London Interbank Offered Rate, like the U.S. Federal Reserve overnight rate, serves as a proxy for the risk-free rate of return. Both refer to the interest on loans banks make amongst each other. Lock Up: Many hedge fund investment strategies require time to generate rewards for investors. To dissuade investors from moving in and out of funds, many hedge funds require investors to stay invested for a minimum period of time, for example, at least one year. Performance fee: Most hedge funds charge a 1% or 2% management fee, plus a 20% fee on the profits, providing the profits exceed the previous high-water mark. Risk-free rate of return: For some managers, the risk-free rate is what they could earn on the money market. For others, it would be the rate earned on inflation-protected bonds. The notion of a risk-free rate is important because, in the absence of broadly recognized investable indexes in the alternative space, it functions as a benchmark. Sharpe ratio: Devised by Nobel Economics Prize winner William Sharpe, the ratio calculates the risk-adjusted return by subtracting the return of a fund from the risk-free rate(treasury bills)and then dividing the return by its volatility or standard deviation. On this score, the S&P 500 has a Sharpe ratio of roughly 0.4. In general, the higher the Sharpe ratio the better; but be careful if the score is much above 2%. There’s the risk of a blow-up. Why? Such a Sharpe ratio equates with a lottery win, rather than consistent exposure to the ups and downs of the markets. Sortino ratio: The Sortino ratio is similar to the Sharpe ratio, except it uses downside volatility. After all, upside volatility—larger than normal gains—is something investors welcome. Survivorship bias: Indexes and databases are constantly reconstituted. Losers are trimmed. That may overstate index returns, particularly among hedge fund indexes. At the same time, the S&P 500 is guilty of survivorship bias too: Not all the firms that were there in 1960 are there now. Vintage year: In the private equity world, a fund’s performance against its peers is dated from the time it made its first investment: its vintage year. |
Scot Blythe is editor of Advisor’s Edge Report. scot.blythe@advisor.rogers.com
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