Hedge Fund Manager Skill Is Misperceived | Chief Investment Officer

(June 28, 2012) — Investors must better distinguish between skill of hedge fund managers and their propensity to take on extra risk, according to Bryan Kelly, a professor of the University of Chicago.

“We want to distinguish between genuine expertise of a hedge fund manager rather than outperforming by taking on extra risk — anyone can take on extra crash risk and get a higher return,” Kelly told aiCIO following the recent release of his academic paper on the topic, which he co-wrote with Erasmus University Professor Hao Jiang.

If investors want to measure risk correctly, they must be more careful about calculating the returns generated by hedge fund managers’ willingness to take tail-risk positions, exposing them to downside risk, according to Kelly’s paper titled “Tail Risk and Hedge Fund Returns.” The main thrust of the research: hedge fund managers tend to be more willing to take on positions that have a high likelihood of crashing in order to earn higher expected returns.

“A common analogy made is to think about earthquake insurance,” Kelly said. “If you’re a writer of earthquake insurance, you will have nice, stable returns. Most of the time you don’t pay out anything — it’s like free money. But when an earthquake hits losses are huge. Hedge fund investing is also a tail risky strategy that loads up on potential for crashes.”

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What’s the solution then to a more accurate portrayal of hedge fund manager alpha?

According to Kelly, the answer lies in the use of a benchmark that takes on more highly risky investments. “We also propose a benchmark that invests in stocks that have a higher likelihood of crashes,” Kelly asserted.

The paper states: “We have shown that hedge funds exhibit persistent exposures to extreme downside risk. For instance, the very same hedge funds that underperformed in the 1998 crisis suffered predictably lower returns during the 2007-2008 crisis…we find that tail risk is an important determinant of the time-series and cross-section variation of hedge fund returns.”

The paper continued to note that the results described in the paper “are consistent with the notion that a significant component of hedge fund returns can be viewed as compensation for providing insurance against tail risk.”

Read the full paper here.

(June 28, 2012) — Investment outsourcing by pension plan sponsors may likely double over the next five years as plan sponsors seek more expertise and faster execution, according to a poll conducted by SEI.

Of the poll participants who are not using a fiduciary manager, 29% said they would likely consider a change to this model within the next five years, potentially more than doubling the use of an outsourced fiduciary manager model by corporate pension plan sponsors by 2017. “As pension plan management becomes more complex, we are seeing a growing demand in the marketplace for outsourced fiduciary management services,” said Kevin Matthews, vice president and managing director at SEI’s Institutional Group. “Working with a fiduciary manager allows plan sponsors to allocate various levels of discretion to an investment partner, whether it be manager research, selection and oversight, or the added layer of discretion over asset allocation decisions.”

According to the poll, the top three drivers for investment outsourcing include:

1. Expert advice across all markets

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2. Faster execution on market changes

3. Delegation of tactical decisions to increase focus on strategy

SEI conducted the poll of 50 corporate defined benefit plan sponsors to determine their organizations’ current and future use of a fiduciary manager and their top reasons for outsourcing the investment management of pension plan assets.

When asked out the reasons for investment outsourcing among pensions, investment heads contacted by aiCIO often cite that asset owners are generally not “natural investors.” In other words, corporate pension plan sponsors are responsible for a large pool of money to protect, but they are often not the most skillful with more complex strategies — such as liability-driven investing and risk parity. Outsourcing, then, is a natural evolution of the industry, CIOs often say.

SEI’s study contrasts with a survey conducted by Russell Investments in March, which noted that large funds are shunning outsourced investment. While fiduciary managers and consultants offering investment outsourcing are picking up more business from small to mid-size pension fund investors, they are failing to take ultimate control of the larger funds, Russell’s research found. By the end of 2011, the number of smaller schemes employing a fiduciary manager or outsourcing expert had grown from 15% to 26% since 2009, Russell Investments said in its governance survey.

Related data:aiCIO Investment Outsourcing Survey