Investcorp is one of the world’s leading institutional investors in hedge funds with $5 billion under management, about $1 billion of which is proprietary. With so much prop. capital in play, Deepak Gurnani, Investcorp’s head of hedge funds and CIO, says the firm sees its interests as being “very much aligned” with those of its investors. And as investors, Investcorp has noticed shortcomings in what Gurnani calls the ‘conventional’ approach to hedge fund investing. In an effort to find a new way to get exposure to the asset class, the company began the Alpha Project in 2003 and Gurnani recently discussed the results of that research with FINalternatives’ Senior Reporter Mary Campbell.
What inspired the Alpha Project?
If you look at the hedge fund industry, there is really only one way to get hedge fund exposure and that way is to look for a manager who does something unique and adds alpha and pay them hedge fund fees—2 and 20, standard fees. If they succeed and generate alpha, then the fees are well spent, but if they do not succeed then a disproportionate amount of the returns do go into fees.
There are four issues with what I call the conventional approach to hedge fund investing. First, the reality is that common components, i.e., the strategy returns, explain a large part of hedge fund returns. We have statistics that show a large part of hedge fund returns is attributable to the strategy as opposed to a unique action by the manager. It can be statistically measured, and we have done that. As more money comes into hedge funds and goes into the larger funds, increasingly the trend is towards more and more strategy returns versus the manager-specific returns.
The second challenge is fees. We have found that, on average, between 50% to 75% of the total alpha goes into fees. So the investors get 25% to 50% of the alpha.
Third, there are risk and transparency concerns, such as blow-ups, style drift, side pockets and fraud like we saw with Madoff and others. We’ve added one more recently—insider trading. So there are lots of these risk and transparency concerns.
The fourth concern is liquidity. We believe additional alpha can be generated by making tactical allocations across strategies, but often the liquidity in the underlying hedge fund does not lend itself to making those tactical shifts.
You say those were your concerns in 2003 when you began the Alpha Project and that they are even more true in 2011. How does the Alpha Project address them?
Since 2003 we’ve researched into factors that drive hedge fund returns and alpha. Academic research tends to focus on market factors to explain hedge fund returns. So they look at the level of equity markets, volatility in the markets, credit spreads, currencies or some other indicators. We actually found that that approach doesn’t work well and abandoned it in 2003.
We feel that the best way to understand what drives hedge fund returns and alpha is to understand the generic trade behind every strategy. Some trades are easier to understand. I’ll pick two examples. For convertible arbitrage, the manager buys a convertible note, delta hedges the equity and will hedge the currency risk, may or may not hedge credit risk, may or may not hedge interest rate risk, and follows this process for a portfolio of convertible bonds. There are nuances to that, but there’s a generic trade. Merger arbitrage is similar. When a company has an announced merger, the hedge fund manager will buy shares in the target company and will short the shares of the acquirer, if it happens to be a stock-by-stock deal, and there’s no underlying hedge, if it’s a cash deal.
Then there are strategies where the trade is less defined or more complex. For example, in equity market neutral, there’s no specific trade, per se, defined as neatly as convertible arbitrage or merger arbitrage. However, equity market neutral managers do tend to invest using factors. We have identified 20 generic factors that make up that strategy.
And then we get into more complex strategies, like fixed-income relative value. We’re also working on CTAs and hedge equities. We’ve pretty much mapped out the generic trades within all the core hedge fund strategies.
Once we identify the trade, we go back in history and collect data on the different trades that go into the strategy. In the case of convertible bond arbitrage, we have gone back to the early 1990s and collected data on all the different convertible bonds, computed what is the hedge against them and computed the performance of that portfolio. We did the same thing with merger arbitrage. We researched every single merger that was defined, going back to the 1990s, and we looked at the performance of that trade. As a result, we have a set of portfolio returns for every strategy. This provides us with a much better reflection of the underlying strategy return versus market factor analysis or the HFR, CSFB or Morningstar indices.
How have you used this information?
We have been using it for two purposes for several years now. First, we have been using it to make more informed tactical allocation decisions across hedge fund strategies. Analyzing strategies in greater detail gives us insight into when the market environment is favorable for a strategy. For example, during the 2008 crisis we were underweight a lot of credit strategies in the portfolio. In 2009, we took an overweight position in arbitrage strategies, especially convertible arbitrage, because our Alpha Project models were showing a great opportunity in that strategy. Similarly, in late 2009, we moved into defaulted debt. Today we are looking at post-bankruptcy equities.
We’re also using the Alpha Project to strengthen our manager-selection capability. Every time we evaluate a manager we compare the performance of the manager to our internal portfolios. We can actually determine if the manager is doing something unique to generate alpha, and whether the manager has truly outperformed.
The third logical use is to actually invest dollars in the same portfolios that we have been using for research and manager evaluation purposes. To the extent that we believe that a large part of the returns come from the strategy itself, we believe a portion of hedge fund allocations should be made to a trade-based implementation, such as the Alpha Project, and a portion to managers who have provided alpha over and above the strategy returns and are doing something unique. So far we have had the tools to evaluate managers, but we want to go one step further and deploy our dollars invested in hedge funds through these various approaches.
What sort of results has your strategy achieved?
We find that the strategy returns have a high correlation to the hedge fund indices. We did not start out by trying to maximize the correlation. We put the indices aside and constructed our own portfolios based on the inherent trade in every strategy. When we compared the performance of the portfolio to the strategy indices, we found that the correlation was high, so that tells us that we are moving in the right direction.
More importantly, we find that our strategy portfolios have a significantly higher Sharpe ratio at the strategy level and at the composite level than the hedge fund indices, which says that it is a superior way for an investor to get exposure to hedge funds.
Also, we factored into the portfolio returns the key transaction and operational costs such as prime brokerage costs, stock borrowing costs, internal controls and liquidity filters. These are all built into the model portfolios generated through the Alpha Project so that the performance reflects the costs associated with actually implementing these portfolios. And even after taking these costs and expenses into consideration, we are able to demonstrate a superior Sharpe ratio to the hedge fund indices, both at the hedge fund level and at the composite level.
You mention concerns about hedge fund fees, and you believe that strategy can be more important than the manager—is this approach difficult to discuss with hedge fund managers? Don’t they consider this a challenge to both their earnings and abilities?
I think the more interesting question is how do investors look at this? As proprietary investors in our own hedge funds, our interests are very aligned with those of our investors. The investors we talk to are saying, on the one hand, that there are the issues with hedge funds, which I mentioned earlier, and on the other, they want to increase their exposure to hedge funds. But we need an alternative way that addresses those issues.
Managers who continue to add alpha have nothing to worry about from this alternative approach. It will put pressure on managers who have historically not added alpha but continue to charge high fees. And I think that’s good for the industry. Alpha by definition is limited. As more money comes into the industry, more of the returns are going to be strategy returns, so why pay 2 and 20 to get the strategy returns? If you can capture strategy returns through more a cost-effective, more liquid and more transparent approach, which is what our trade-based implementation offers, it’s a win from an investor standpoint.
You’ve been discussing the system with potential investors, what sort of response have you been getting?
We’ve been [getting a] very positive response from investors. In fact, we presented the Alpha Project at an investor event last December and subsequent to that event we got a lot of inquiries from our investors asking why we don’t launch it as an investible product. And for the last four or five weeks, I’ve been meeting with institutions all over the country and in Canada, and we have gotten a tremendous response. I would say eight or nine out of 10 institutions that we met expressed a very strong interest in potentially doing something with the idea.
It’s said that with more (and bigger) institutions entering the alternatives space, the balance of power is shifting toward investors. Do you think this is the case?
I think that trend started at the beginning of the century when more institutional money first began coming in. This has certainly been positive in a lot of ways for the industry. I think the industry, on the balance, has become more transparent. But again, 2008 showed that there are issues in the industry.
My concern today is that, with a lot of money coming into hedge funds, capacity with managers who truly add alpha is going to be limited. When the demand/supply dynamic favors money coming in and capacity is limited, I wonder whether the balance that you were talking about is going to shift again [in favor of managers].
I think the industry has taken lots of steps in the right direction, and will continue to do so. At the same time, I do think that institutional investors need to continue to insist on and fight for what is important—and I count ourselves in group that because we’re a big institutional investor in hedge funds, having $1 billion of proprietary capital invested in hedge funds.