Interview with Robert Kosowski, Imperial College London

Robert KosowskiRobert Kosowski is Associate Professor in the Finance Group of Imperial College Business School, Imperial College London, and Director of the Risk Management Lab and Centre for Hedge Fund Research.  Robert is an associate member of the Oxford-Man Institute of Quantitative Finance at Oxford University, an Affiliate Professor at the EDHEC Risk Institute and a member of AIMA’s research committee. Robert holds a BA (First Class Honours) and MA in Economics from Trinity College, Cambridge University, and a MSc in Economics and PhD from the London School of Economics. Robert has consulted for private and public sector organizations and has worked for Goldman Sachs, the Boston Consulting Group and Deutsche Bank. His policy related advisory work includes: Specialist Adviser to UK House of Lords (2009-2010), Expert Technical Consultant (International Monetary Fund, USA, 2008). As he and Dr. Juha Joenväärä (Assistant Professor at the University of Oulu) recently published a study together comparing traditional hedge funds with UCITS hedge funds, we sat down with him to find out more. You recently published a study called “An Analysis of the Convergence between Mainstream and Alternative Asset Management”. What were your key findings?

Robert Kosowski: Our analysis reveals three key findings. First, we compared the performance of the average hedge fund (HF) from commonly used commercial hedge fund data bases with the average UCITS hedge fund or absolute return UCITS fund (ARUs). We found that on average the performance of HFs was higher than that of ARUs over our sample period (2003-2011). This result also held by investment objective and on a total return as well as risk adjusted (Sharpe Ratio or alpha) basis. However, ARUs have notice periods of just 2 days while the average hedge fund in our sample has a notice period of 33 days which means that ignoring the liquidity differences is like comparing apples and oranges. Therefore we next liquidity or share restriction matched all the European domiciled HFs and ARUs. This led to our second main finding which was that on a liquidity-matched basis HFs’ and ARUs’ performance was statistically insignificant from each other. Our third finding was that the relationship between the performance of the two groups varies over time and most of the HF outperformance stems from the recent period. What techniques do hedge fund managers use currently the most and which are transported into regulated vehicles according to your research?

Kosowski: Given the large number of techniques it is useful to categorize the techniques into three main groups and several subgroups. The three main groups that we use are (1) risk management techniques, (2) alpha creation techniques and (3) techniques related to leverage. Of course, some techniques may fall into more than one category. Within the first group we distinguish: 1.1.Techniques to change the fund return distribution by means of derivatives (futures, forwards, options, swaps and other derivatives), 1.2. Techniques to change the fund return distribution by means of dynamic (option-like) trading strategies (portfolio insurance), 1.3. Volatility scaling of positions, 1.4. Risk measurement techniques (VaR, EVT, advanced risk measures), 1.5. Currency overlay, 1.6. Performance-enhancing compensation and incentive structures (high water marks, performance fees, clawback). The second group contains: 2.1. Advanced econometric and forecasting techniques for Global Tactical Asset Allocation, 2.2 Asset-specific bets and stock-picking, 2.3 Shareholder activism, 2.4 Order Execution Alpha, 2.5 Currency Alpha. Finally we distinguish the following within the group of leverage related techniques: 3.1 Financial Leverage (borrowing leverage and /or notional leverage; prime broker funding), 3.2 Construction leverage (Shorting as a source of Leverage), 3.3 Instrument leverage, 3.4 Risk-parity techniques, 3.5 VaR techniques and leverage. Many of the techniques listed above can be transported to the UCITS space but the exceptions are related to certain restrictions concerning the use of derivatives and shorting as well as the permissibility of illiquid assets. Looking forward there might also be differences related to the ability of asset management firms to compensate their managers since the UCITS VI proposal envisages performance bonus caps that are not part of the AIFMD. What did you observe that supports the perceived trend of the convergence of the alternative and mutual fund space?

Kosowski: There are three factors that can contribute to the converence. First, regulation in the form of UCITS III in 2002 has increased the number of eligible assets that UCITS funds can hold including derivatives which made hedge fund like strategies possible. Second, for hedge funds the ability to access a large UCITS investor base makes creating UCITS share classes attractive, as the case of Paulson in 2010 demonstrates. For mutual funds, the more attractive fee structures of HFs provide incentives to create hedge fund like strategies. Third, the number of ARUs in our sample has grown 700 percent since 2003. However, one has to bear in mind that there are caveats related to the comparison of the group of HFs and ARUs since there is some evidence of survivorship bias among ARUs within the early period from 2003 to 2007. You examined the relationship of performance and risk in particular and found out that non-UCITS hedge funds return better results in that regard than their UCITS counterparts. What are the reasons and why should people invest in UCITS hedge funds then?

Kosowski: Absolute return UCITS funds are subject to certain restrictions that non-UCITS hedge funds do not suffer from. We find that the volatility and betas of UCITS hedge funds or ARUs is higher than that of non-UCITS hedge funds. This is consistent with restrictions on the use of derivatives and shorting having an impact on the ability to hedge. Moreover, the liquidity restrictions imply that ARUs cannot hold certain illiquid or distressed assets that may earn a liquidity premium, thus reducing performance further. In addition, some Event Driven strategies such as‘ Activism’ are not common among UCITS hedge funds. However, one of our key findings is a performance-liquidity tradeoff. Once we adjust for liquidity differences the performance of ARUs and HFs is statistically insignificant from each other within the group of funds that are domiciled in Europe. This means that investors may want to invest in UCITS hedge funds due to their superior liquidity on average. Of course this superior liquidity compares at cost. If the tradeoff is acceptable then it is one reason why UCITS hedge funds have a role to play. Another reason for investing in UCITS hedge funds is the additional regulatory scrutiny that ARUs are subject to. Thank you for the interview.