How do current market activities, regulatory changes and dislocations potentially impact the ability of hedge funds to prosper going forward? The huge changes occurring in the markets are having a significant impact on hedge funds, including short sale restrictions, disclosure requirements and the effective elimination of the investment banking model and its attendant impact on sources of funds to provide leverage and liquidity.

Current and potential hedge fund investors should be aware of changes in the market and should monitor investments closely, including asking additional questions of their hedge fund managers and gathering vital market and regulatory information. Fiduciaries should not take a “wait and see” approach, but should pursue key information in order to make prudent decisions.

Over the last 12 months global financial markets have undergone major corrections following, fundamentally, a break-down in the confidence and trust in the financial system as practiced by the Western world.

Along with this break-down we experienced a steep fall in US housing prices, the nationalization of financial institutions, the forced merger and/or failure of several large financial institutions in the US and Europe, and a global credit freeze.

The crisis has led us into an economic recession.

 

Activist investing is an investment approach whereby an investor seeks to influence the strategy of a company. Strategy may be very broadly defined to include acquisitions, divestitures, capital structure, dividend policy and board composition, inter alia.

We see two broad aspects of this strategy that may exist separately or together. First, activist investing may seek to remedy conflicts of interest in corporate governance. Secondly, it may be seen as a derivative strategy of value investing that attempts not only to identify undervalued companies, but also to engage those companies to pursue actions that will realize shareholder value.

We believe activist strategies should be considered as a part of investors’ equity portfolios.

Alpha is shrinking, and it’s good news for investors. This idea may seem paradoxical. But alpha is really just the portion of a portfolio’s returns that cannot be explained by exposure to common risk factors (betas).

With the emergence of new betas, the unexplained portion (alpha) shrinks – alpha gets reclassified as beta. The rise of a group of risk factors we call hedge fund betas makes this transformation especially relevant today. Hedge fund betas are the common risk exposures shared by hedge fund managers pursuing similar strategies.

We believe these risk factors can capture not just the fundamental insights of hedge funds, but also a meaningful portion of their returns. Hedge fund betas are available for investment and can also be used to enhance portfolio construction and risk management.

Ultimately, we believe the rise of hedge fund betas will lead not only to the reclassification of alpha, but also to better-diversified portfolios with greater transparency, improved risk control, and – perhaps most importantly – higher net returns.

 

Recent pricing dislocations in U.S. fixed-income markets have illustrated there is more to hedging a liability’s interest rate risk than simply matching its duration. Basis risk – in the context of liability hedging – is the risk that the changes in the market value of assets, designated as a hedge, will deviate from the changes in the value of the appropriate liability benchmark.

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Diversification is one of the few reliable ‘free lunches’ in asset markets. Nevertheless, investors do not always extract the best from the available benefits. Many portfolios still carry some concentrated risk exposures. And when diversification is pursued, it often occurs under the shotgun approach of increasing the number of return sources, albeit guided by a focus on correlation.

This report is the first of a two-part series that proposes a more rifle-shot approach to diversification. It suggests a general process for improving the asset class mix of an existing portfolio. The method involves identifying the underlying fundamental risks to which the portfolio is most exposed, the purposefully diversifying towards assets that address these risks.

Part B of the series discusses the hunt for excess returns.