Lecture for the first module of Hedge Fund Elective E416 at London Business School, delivered on 3 May 2013

1. Hedge Funds: Data
Dr Drago Indjic
Sunningdale Capital
dindjic@london.edu
May 2013

2. Data on Hedge Funds
• Industry, but Regulated
– Size and growth of “professional” funds
• Business
– Entrepreneurs and their ventures
• Product: Funds
– Data: reference, product, business and
market data

3. Macro View
• Size of AUM: $2.4 t (est. 2013Q1)
• Exceeds pre-crisis peak (2007); >50%+ over low
$1.3 tn (1Q09); inflows $15b; ~10k funds (1,108
born vs 873 died (2011: 1,113 / 775), concentrated
• ~ ETF products, top 3 SWF or <Blackrock $3.8t
• The largest hedge funds are ~$132b SPDR ETF
• Better businesses today
• Consolidating value chain, more regulated
• Survivors: 2008 crisis was an extraordinary year
for managed futures strategy (+15%)

4. MBA View of Value Chain
• Demand: “cheap Alpha”
– End investors: direct and indirect sourcing
• Intermediaries: FoHF ($650b in 2013Q1)
– Imperfect market of “professional” funds; Off-
shore fund services industry
• Supply: start ups vs mature businesses
– Hedge fund managers as innovators; never
too big to fail (LTCM; Pelaton)

5. Fin de siecle
• Financial “repression” era
– Hedge funds as exit strategy: “unbundling” of
bank’s proprietary trading desk
– An employee (trader) has to become an
entrepreneur, through a prime brokerage
agreement and other services - including
raising his own funds, but business costs
increasing
• EU AIFMD, Dodd-Frank, SEC etc

6. Regulation

7. Fund Management Company
• Start-up, not a public listed corporate
• Manager(s) = Founders-owners; micro-enterprise
(think credit score); cash-flow sensitive; taxable
• Careful structuring
• Regulated entity and approved personnel
• On-shore: (UK: FCA) authorised LLP (private LLP
agreements); staff, systems, service contracts
• Off-shore Ltd, corporate “substance” and
governance, authorised (eg. Guernsey FSC)
manages off-shore fund

8. Legal Documentation
• People: Partnership agreement
– Equity%: ownership, not salaried partners;
control and economics
• Fund manager: Articles of incorporation
• Fund: private placing memorandum
– Investment management agreement
– Subscription forms (often “non US”)
• Service agreements
– Counterparties, directors, distributors …

9. Private Fund
• Separate legal entity: off-shore
incorporated, controlled and audited
• Governance (off-shore non-exec directors): non-
voting investor shares: potential mismatch of
investor expectations and fund board powers
• Tax benefits for international investors
• Private placement
• on-shore distribution: business model of 3rd party
fund marketers and fund of funds (pooled, open-
ended fund vehicles)

10. Counterparties and Services
• Prime broker
– (+) Bank: securities lending and financing
– (-) Most senior creditor: re-hypothecation
(Lehman; MF Global)
• Fund Administrator
– NAV Calculator, registrar and transfer agent
– Traditionally priced monthly, redemption less
often
• Auditor, lawyer, secretarial services …
– Compliance, 3rd party marketing, IT …

11. Investors
• Eligibility
– KYC and AML client classification; direct or
indirect (HNW, pension plans or FoF)
– An investor domiciled in X buys units of fund
domiciled in jurisdiction Y: who should pays
taxes – and where?
• Marketing and business strategy
– Performance/flows: AUM may stay around
$100m for a long time (eg. Molinero LLP)

12. Micro-Enterprises
• Owner/Manager’s LLP
– Staff <10: the largest are still SME!
• Median “fund” AUM <$50m
– Today less profitable then in the past; higher
cost of seed capital
• Very few long-term survivors and “brands”
– Most liquidated within 7 years
– not unlike many other start-up businesses

13. Myths: Cashflow, Not “Blow Up”,
($1,000)
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
$0.0
$10.0
$20.0
$30.0
$40.0
$50.0
$60.0
$70.0
$80.0

14. Case Study: Leverage - Lower

15. Case Study: Fees - Lower
• Clive Capital LLP, Europe’s biggest commodity hedge fund, will cut
its fees after posting two consecutive years of losses, according to a
letter sent to clients today.
• Clive will start charging investors in its class B
shares a 2%/20% from April, down from
2.5%/25%. The decision comes after client
withdrawals and investment losses prompted
AUM to shrink 46% to $1.95 billion.
• Clive, which was founded by former Moore Capital Management
LLC trader Chris Levett, slumped 8.8% last year after falling 9.9% in
2011. Investors had been willing to pay a premium to Clive after it
outperformed rivals in previous years, gaining 44% in 2008, 17% in
2009 and 20% in 2010 (Bloomberg, 8 February 2013)

16. Case: Liquidity - Better
• With about three weeks before investors in SAC need to decide on
whether they are pulling their money out, Cohen is offering them a
quicker way to in a bid to convince them to stick with him.
• Investors will now be able to get back 50% of their
money in each of the last two quarters of the year, the
firm told investors. Initially, the firm would pay back
withdrawals spread out over four quarters. Then the firm
hastened the payouts to one third of investors' fund
stakes per quarter and now it will be half per quarter.
• This marks the second time in about two months that SAC has
adjusted its liquidity conditions. Outsiders' money accounts for only
about $6 billion of the AUM, but Cohen appears to be trying to pacify
jittery clients who said in February that they wanted to pull out $1.7
billion at the end of the first quarter (Reuters, 26 April 2013)

17. Data Sources
• No standard security identifiers
• Bloomberg etc screens are blank; data is not for
sale by fund administrators or brokers
• Specialist databases
• Low quality: mainly “catalogues” of 1,000+
management companies by market research
specialists like HFR, Lipper, Morningstar
• Lagged performance estimates for 20k+ fund
share classes and fund “boiler plates”
• Self-selection and survivorship bias: the largest,
the smallest and “defunct” funds excluded

18. Fundamental Data
• Mostly private, lagged and age fast
– Static reference data
• Fund offering memorandum, counterparties
– Business
• Due diligence: staffing, references, accounts
• “Skin in the game”: monitoring incentives, conflicts
and sustainability
– Portfolio
• portfolio exposure and holdings (“Opera” standard
aggregated), weekly NAV, investor letters ...

19. It Was Just One of Many Funds

20. Investment Strategies
• What exactly is a strategy?
– Lack of standard definitions – or indices -
beyond labelling: stated in interviews and
case studies
– Transparency: necessary, not sufficient
criteria
• Lack of verification
– Benchmarking and replication applications;
contract law: Legal text vs legal evidence

21. Indicative “Strategies”
• Danger: overpaying for Beta-like service
• Not all “hedge” funds deploy hedging
strategies; varies across universe and time
Equity Hedge
38.52%
Emerging Markets (Total)
5.53%
Distressed Securities
2.74%
Equity Market Neutral
5.94%
Equity Non-Hedge
7.84%
Event-Driven 7.28%
FI: Arbitrage 2.78%
FI: Convertible Bonds
0.25%
FI: Diversified 2.56%
FI: High Yield 1.14%
FI: MBS 1.37%
Convertible Arbitrage
3.70%
Short Selling
0.76%Sector (Total) 6.71%
Macro 2.15%
Market Timing 3.65%
Merger Arbitrage 3.78%
Regulation D 0.52%
Relative Value Arbitrage
2.77%
Estimated Strategy Composition by # of Funds (ex
FOF) 2002

22. Indexes are Composites
• “Broad” indexes are just (non-investable)
peer groups
• No reliable multi-source industry statistics
• “average” performance, #hedge funds,
#management companies; % Strategies,
domiciles, counterparties; $AUM, flows, liquidity,
age; micro data: #births/deaths …
• Questionable Ranking
• Statistical, operational or any other attributes in
typical investment mandate search (infeasible!)

23. Index Performance
• “non-investable” (HFRI) vs “investable”

24. Exposure
• Extinct and endangered
• Structured: capital protected – disappeared
• FoHF: full outsourcing, consultant’s stronghold
• Thriving
• Advisors: outsourced due diligence
• Managed Account Platforms
• Direct: many endowments, pension funds
• Emerging
• UCITS and index products

25. Risk and Reward
• Evaluate Total Hedge Fund Risk
– Mostly business risk: contractual, SME, “key
man” LP’s “exit”, no EV, equity financed
– Lesser portfolio and market risk (“hedged”)
• Benefits
– Unique risk/return profiles (units priced in gold
or oil): not dependant on underlying assets
– Negotiable investment terms, business co-
ownership (PE-like); discovery of fair active
management “price”

26. Conclusion
• Global political economy
– “On-shoring”; private equity is excluded from
AIFMD
– High frequency traders became new “bad
boys”
• New passive / active boundaries
– Active ETFs; “newcits”