High-frequency trading is quantitative trading that is by 5N343H


									Securities Laws Issues In Electronic Trades: HIGH FREQUENCY
By: Susan M. Hinds, JD, CPA, MBA

    1) High Frequency Trading

    a. Defined: High-frequency trading (HFT) is the use of sophisticated technological tools to trade
        securities like stocks or options, and is typically characterized by several distinguishing

           It is highly quantitative, employing computerized algorithms to analyze incoming market data
            and implement proprietary trading strategies;
           An investment position is held only for very brief periods of time - from seconds to hours - and
            rapidly trades into and out of those positions, sometimes thousands or tens of thousands of
            times a day;
           At the end of a trading day there is no net investment position;
           It is mostly employed by proprietary firms or on proprietary trading desks in larger, diversified
           It is very sensitive to the processing speed of markets and of their own access to the market;
           Many high-frequency traders provide liquidity and price discovery to the markets through
            market-making and arbitrage trading; high-frequency traders also take liquidity to manage
            risk or lock in profits.
        Positions are taken in equities, options, futures, ETFs, currencies, and other financial instruments
        that can be traded electronically.

        High-frequency traders compete on a basis of speed with other high-frequency traders, not long-
        term investors (who typically look for opportunities over a period of weeks, months, or years), and
        compete for very small, consistent profits. As a result, high-frequency trading has been shown to
        have a potential Sharpe ratio (measure of reward per unit of risk) thousands of times higher than
        the traditional buy-and-hold strategies.
    b. Securities Law Impacted:
        - Insider Trading Laws: (’public information’ not disseminated to market sufficiently to be
        considered public information to average investors…denies equal access to market
        - Market Manipulation:
High-frequency trading is quantitative trading that is characterized by short portfolio holding periods (see
Wilmott (2008)). All portfolio-allocation decisions are made by computerized quantitative models. The
success of high-frequency trading strategies is largely driven by their ability to simultaneously process
volumes of information, something ordinary human traders cannot do. Specific algorithms are closely
guarded by their owners and are known as "algos".
Most high-frequency trading strategies fall within one of the following trading strategies:
   Market making
   Ticker tape trading
   Event arbitrage
   High-frequency statistical arbitrage
Market making
Market making is a set of high-frequency trading strategies that involve placing a limit order to sell (or
offer) or a buy limit order (or bid) in order to earn the bid-ask spread. By doing so, market makers provide
counterpart to incoming market orders. Although the role of market maker was traditionally fulfilled by
specialist firms, this class of strategy is now implemented by a large range of
investors, thanks to wide adoption of direct market access. As pointed out by
empirical studies this renewed competition among liquidity providers causes
reduced effective market spreads, and therefore reduced indirect costs for final
Some high-frequency trading firms use market making as their primary trading strategy. Automated
Trading Desk, which was bought by Citigroup in July 2007, has been an active market maker, accounting
for about 6% of total volume on both the NASDAQ and the New York Stock Exchange. Building up
market making strategies typically involves precise modeling of the target market
                [27][28]                                              [29][30][31]
microstructure           together with stochastic control techniques.
These strategies appear intimately related to the entry of new electronic venues. Academic study of Chi-
X's entry into the European equity market reveals that its launch coincided with a large HFT that made
markets using both the incumbent market, NYSE-Euronext, and the new market, Chi-X. The study shows
that the new market provided ideal conditions for HFT market-making, low fees (i.e., rebates for quotes
that led to execution) and a fast system, yet the HFT was equally active in the incumbent market to
                  New market entry and HFT arrival are further shown
offload nonzero positions.
to coincide with a significant improvement in liquidity supply [INSERT

    c. Scope: $2 Trillion in Assests and 50% trade in frequency?
    d. Solution: No TARP money allowed

    2) Momentum Trading- (TBD- NOTE: it is different as it trades on direction
       not speed…)
        Securities Law Impacted:

Excerpt from Hedge Fund Management Industry Profile
(source: http://www.firstresearch.com/Industry-Research/Hedge-Fund-Management.html)
Hedge Fund Management Industry Profile
                Page Length:                  10-12

                Last Quarterly Update:        7/16/2012

                SIC Codes:                    6211

                NAICS Codes:                  523920

Hedge Fund Management Industry

The US hedge fund industry includes thousands of companies with combined assets of more than $1 trillion.
Many large funds headquartered in the US operate internationally. The largest US-based hedge funds include
Bridgewater Associates, JP Morgan Asset Management, Highbridge Capital Management, and Paulson & Co.

The global hedge fund industry is a $2 trillion market by total assets under management, according to

Deutsche Bank. The largest non-US funds include Brazilian hedge fund Gavea Investimentos and

London-based firms Man Investments, AHL, and GLG Partners. Economic growth in Asia and South
America is causing hedge funds in those regions to multiply.


Demand for hedge fund services is driven by the growth of investment capital managed by institutional investors.

The profitability of individual funds depends on investment expertise. Large funds can more easily participate in big

financial transactions. Small funds can compete effectively through specialized investment strategies. The industry
is capital-intensive. Hedge funds are unregulated investment pools that, unlike mutual funds, can engage in a wide

variety of investment activities. Hedge funds are typically organized, marketed, and operated by an individual or
institution that also serves as the fund's investment adviser.

Hedge funds operate much like mutual funds, but are also able to trade financial derivatives and to take "short"

positions, in which investors sell borrowed shares of stock in anticipation of a decline in value, and buy them back at
a profit.

About Hedge Funds (source: Hedge fund Association:                                              http://thehfa.org)

Contributed by Dion Friedland, Chairman, Magnum Funds

Hedge funds refer to funds that can use one or more alternative investment strategies, including hedging against market
downturns, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such
as leverage, derivatives, and arbitrage.

At a time when world stock markets appear to have reached excessive valuations and may be due for further correction,
hedge funds provide a viable alternative to investors seeking capital appreciation as well as capital preservation in bear
markets. The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal.

It is important to understand the differences between the various hedge fund strategies because all hedge
funds are not the same -- investment returns, volatility, and risk vary enormously among the different
hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver
consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual

Key characteristics of hedge funds
Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.
Hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as
puts, calls, options, futures, etc.). Hedge funds benefit by heavily weighting hedge fund managers’
remuneration towards performance incentives, thus attracting the best brains in the investment business.

Facts about hedge funds
           Estimated to be a $2 trillion industry and growing every year, with approximately 10,000 active
            hedge funds.
           Includes a variety of investment strategies, some of which use leverage and derivatives while others
            are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce
            market risk specifically by shorting equities or derivatives.
           Most hedge funds are highly specialized, relying on the specific expertise of the manager or
            management team.
           Performance of many hedge fund strategies, particularly relative value strategies, is not dependent
            on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit
            trusts), which are generally 100% exposed to market risk.
           Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital
            they can successfully employ before returns diminish. As a result, many successful hedge fund
            managers limit the amount of capital they will accept.
           Hedge fund managers are generally highly professional, disciplined and diligent.
           Their returns over a sustained period of time have outperformed standard equity and bond indexes
            with less volatility and less risk of loss than equities.
                     Beyond the averages, there are some truly outstanding performers.
                     Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss
                      and other private banks, who have lived through, and understand the consequences of, major stock
                      market corrections. Many endowments and pension funds allocate assets to hedge funds.

              Popular hedge fund strategies

Popular Misconception
The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional
bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are
global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Aggressive Growth: Invests in equities expected to experience       Market Neutral - Securities Hedging: Invests equally in long and
acceleration in growth of earnings per share. Generally high P/E    short equity portfolios generally in the same sectors of the
ratios, low or no dividends; often smaller and micro cap stocks     market. Market risk is greatly reduced, but effective stock
which are expected to experience rapid growth. Includes sector      analysis and stock picking is essential to obtaining meaningful
specialist funds such as technology, banking, or biotechnology.     results. Leverage may be used to enhance returns. Usually low or
Hedges by shorting equities where earnings disappointment is        no correlation to the market. Sometimes uses market index
expected or by shorting stock indexes. Tends to be "long-           futures to hedge out systematic (market) risk. Relative
biased." Expected Volatility: High                                  benchmark index usually T-bills. Expected Volatility: Low

Distressed Securities: Buys equity, debt, or trade claims at deep   Market Timing: Allocates assets among different asset classes
discounts of companies in or facing bankruptcy or                   depending on the manager’s view of the economic or market
reorganization. Profits from the market’s lack of understanding     outlook. Portfolio emphasis may swing widely between asset
of the true value of the deeply discounted securities and           classes. Unpredictability of market movements and the difficulty
because the majority of institutional investors cannot own below    of timing entry and exit from markets adds to the volatility of this
investment grade securities. (This selling pressure creates the     strategy. Expected Volatility: High
deep discount.) Results generally not dependent on the direction
of the markets. Expected Volatility: Low - Moderate

For more information, view article on distressed securities      Opportunistic: Investment theme changes from strategy to
                                                                 strategy as opportunities arise to profit from events such as IPOs,
                                                                 sudden price changes often caused by an interim earnings
                                                                 disappointment, hostile bids, and other event-driven
                                                                 opportunities. May utilize several of these investing styles at a
Emerging Markets: Invests in equity or debt of emerging (less    given time and is not restricted to any particular investment
mature) markets which tend to have higher inflation and volatile approach or asset class. Expected Volatility: Variable
growth. Short selling is not permitted in many emerging
markets, and, therefore, effective hedging is often not available,
although Brady debt can be partially hedged via U.S. Treasury
futures and currency markets. Expected Volatility: Very High       Multi Strategy: Investment approach is diversified by employing
                                                                   various strategies simultaneously to realize short- and long-term
                                                                   gains. Other strategies may include systems trading such as trend
                                                                   following and various diversified technical strategies. This style of
Fund of Funds: Mixes and matches hedge funds and other             investing allows the manager to overweight or underweight
pooled investment vehicles. This blending of different strategies different strategies to best capitalize on current investment
and asset classes aims to provide a more stable long-term
                                                                   opportunities. Expected Volatility: Variable
investment return than any of the individual funds. Returns, risk,
and volatility can be controlled by the mix of underlying
strategies and funds. Capital preservation is generally an
important consideration. Volatility depends on the mix and ratio Short Selling: Sells securities short in anticipation of being able to
of strategies employed. Expected Volatility: Low - Moderate        rebuy them at a future date at a lower price due to the manager’s
                                                                   assessment of the overvaluation of the securities, or the market,
                                                                   or in anticipation of earnings disappointments often due to
                                                                   accounting irregularities, new competition, change of
Income: Invests with primary focus on yield or current income
                                                                   management, etc. Often used as a hedge to offset long-only
rather than solely on capital gains. May utilize leverage to buy   portfolios and by those who feel the market is approaching a
bonds and sometimes fixed income derivatives in order to profit
                                                                   bearish cycle. High risk. Expected Volatility: Very High
from principal appreciation and interest income. Expected
Volatility: Low

For more information, view article on special-situations fixed-       Special Situations: Invests in event-driven situations such as
income investing.                                                     mergers, hostile takeovers, reorganizations, or leveraged buy
                                                                      outs. May involve simultaneous purchase of stock in companies
                                                                      being acquired, and the sale of stock in its acquirer, hoping to
Macro: Aims to profit from changes in global economies,               profit from the spread between the current market price and the
typically brought about by shifts in government policy which          ultimate purchase price of the company. May also utilize
impact interest rates, in turn affecting currency, stock, and bond derivatives to leverage returns and to hedge out interest rate
markets. Participates in all major markets -- equities, bonds,        and/or market risk. Results generally not dependent on direction
currencies and commodities -- though not always at the same           of market. Expected Volatility: Moderate
time. Uses leverage and derivatives to accentuate the impact of For more information, view article on merger arbitrage.
market moves. Utilizes hedging, but leveraged directional bets
tend to make the largest impact on performance. Expected
Volatility: Very High
                                                                      Value: Invests in securities perceived to be selling at deep
                                                                      discounts to their intrinsic or potential worth. Such securities may
                                                                      be out of favour or underfollowed by analysts. Long-term holding,
Market Neutral - Arbitrage: Attempts to hedge out most market patience, and strong discipline are often required until the
risk by taking offsetting positions, often in different securities of ultimate value is recognized by the market. Expected Volatility:
the same issuer. For example, can be long convertible bonds and
                                                                      Low - Moderate
short the underlying issuers equity. May also use futures to
hedge out interest rate risk. Focuses on obtaining returns with
low or no correlation to both the equity and bond markets.
These relative value strategies include fixed income arbitrage,
mortgage backed securities, capital structure arbitrage, and
closed-end fund arbitrage. Expected Volatility: Low

              Hedge Fund Industry
              Source: http://www.robsoncapital.com/docs/ROBSON_READING_AIMA_HF_Primer.pdf

              AIMA Canada Hedge Fund Primer is designed to assist the financial community and investors in
              their understanding of hedge funds. The document covers the hedge fund market in Canada,
              hedge fund strategies, and the risk/return characteristics of hedge funds. It is also designed to
              assist financial advisors and investors in their decision to allocate hedge funds in a diversified

              A number of Canadian institutional and individual investors have already recognized the
              advantages of investing in hedge funds. Given the steady increase in hedge funds offered in the
              Canadian marketplace, more investors will begin to recognize the benefits of including hedge
              funds in a diversified portfolio.

              History of the Hedge Fund Industry

              Over the past 50 years, the hedge fund industry has grown from a handful of fund managers in the

              US into a global business at the forefront of investment innovation.

              THE PERIOD 1949-1984

              Alfred Jones, who established the first hedge fund in the US in 1949, is considered the father of

              hedge funds. Jones wanted to create a fund that offered protection in a falling market, while

              achieving superior returns over the long run. Jones’ model was based on the premise that

              performance depends more on stock selection than market direction. To achieve this goal, Jones
used two speculative tools – short selling and leverage – and merged them into a conservative

strategy for investing in both rising and falling markets. Jones set up his fund as a general

partnership with performance-based fee compensation, and invested his own capital in the fund.

The fund was converted to a limited partnership in 1952.

Jones believed that in rising markets, one could buy stocks that would rise more than the market,

and sell short stocks that would rise less than the market. In falling markets, one could buy stocks

that would fall less than the market, and sell short stocks that would fall more than the market. By

balancing these strategies, Jones believed that his fund could yield a net profit in both rising and

falling markets. In fact, during the 1950s and 1960s, Jones’ hedge fund consistently outperformed

the best equity mutual funds.

Jones’ success led many new hedge fund managers to enter the marketplace, and by 1968 there

were approximately 200 hedge funds in the US, including those managed by George Soros and

Michael Steinhardt. However, during the 1960s’ bull market, many hedge fund managers decided

not to follow Jones’ model, as they ceased selling short but continued to lever their long positions.

Consequently, many of these new hedge funds did not survive during the bear market of the 1970s,

and by 1984 there were only 68 hedge funds. Meanwhile, Jones’ hedge fund continued its success
during the 1970s, and over time he hired other stock pickers to autonomously manage portions of his
fund. In 1984, Jones created a “fund-offunds” by amending his partnership agreement to reflect a
formal fund-of-funds structure.

THE PERIOD 1985-2004

The growth in the hedge fund industry accelerated in the 1980s and 1990s. During this time, an

increase in new financial vehicles, and changes in technology, facilitated the development of
sophisticated investment strategies without the need for backing by large investment houses.

In addition, performance-based incentive fees and low barriers to entry for new funds, led highly

skilled entrepreneurial investment professionals to leave large investment houses to start up their

own hedge funds. Some of these managers had initial financial backing from their former

employers, and many invested their own investment capital in their funds.

During the 1980s, most US hedge fund managers did not register with the Securities and Exchange

Commission (SEC). Hence, they were prohibited from advertising and relied on word-of-mouth

referrals to grow their assets. During this period, European investors also recognized the

advantages of hedge funds, and this fueled the growth of many tax-efficient offshore hedge funds.

The 1980s and 1990s saw a significant period of growth for hedge funds, with exceptional

performance from a number of star managers. For example, Julian Robertson’s Jaguar Fund,

Steinhardt’s Steinhardt Partners and Soros’ Quantum Fund earned compound returns in excess of

30%. Not only did these managers outperform in bull markets, but also in bear markets.

By the end of the 1990s, hedge funds were attracting money from multiple parties, including family

offices, high-net-worth individuals, private banks (mostly European), US endowments and

foundations, insurance companies, pension plan sponsors and hedge fund-of-funds (FOFs).

THE PERIOD 1985-2004

The growth in the hedge fund industry accelerated in the 1980s and 1990s. During this time, an

increase in new financial vehicles, and changes in technology, facilitated the development of

sophisticated investment strategies without the need for backing by large investment houses.
In addition, performance-based incentive fees and low barriers to entry for new funds, led highly

skilled entrepreneurial investment professionals to leave large investment houses to start up their

own hedge funds. Some of these managers had initial financial backing from their former

employers, and many invested their own investment capital in their funds.

During the 1980s, most US hedge fund managers did not register with the Securities and Exchange

Commission (SEC). Hence, they were prohibited from advertising and relied on word-of-mouth

referrals to grow their assets. During this period, European investors also recognized the

advantages of hedge funds, and this fueled the growth of many tax-efficient offshore hedge funds.

The 1980s and 1990s saw a significant period of growth for hedge funds, with exceptional

performance from a number of star managers. For example, Julian Robertson’s Jaguar Fund,

Steinhardt’s Steinhardt Partners and Soros’ Quantum Fund earned compound returns in excess of

30%. Not only did these managers outperform in bull markets, but also in bear markets.

By the end of the 1990s, hedge funds were attracting money from multiple parties, including family

offices, high-net-worth individuals, private banks (mostly European), US endowments and

foundations, insurance companies, pension plan sponsors and hedge fund-of-funds (FOFs).

Hedge Funds: The New Dumb Money
By Mad Hedge Fund Trader |22 August 2012 (source: http://oilprice.com/Finance/the-
Much of the fury in this morning's nearly 60 point "melt up" opening in the Dow was generated by hedge
funds panicking to cover shorts. Convinced of the imminent collapse of Europe, the impotence of
governments, and the death spiral in sovereign bonds, many managers were running a maximum short
position at the opening, and for the umpteenth time, were forced to cover at a loss. Meet the new dumb
money: hedge funds.

When I first started on Wall Street in the seventies, you heard a lot about the "dumb money." This was a
referral to the low end retail investors who bought the research, hook-line-and-sinker, loyally subscribed
to every IPO, religiously bought every top, and sold every bottom.

Needless to say, such clients didn't survive very long, and retail stock brokerage evolved into a volume
business, endlessly seeking to replace outgoing suckers with new ones. When one asked "Where are the
customers' yachts," everyone in the industry new the grim answer.

Since the popping of the dot-com boom in 2000, the individual investor has finally started to smarten up.
They bailed en masse from equities, seeking to plow their fortunes into real estate, which everyone knew
never went down. Since 2007, the exit from equities has accelerated.

Although I don't have the hard data to back it, I bet the average individual investor is outperforming the
average hedge fund in 2012 by a large margin. With such heavy weightings of bonds, including the
municipal, corporate, and government flavors, how could it be otherwise? While the current yields are
miniscule, the capital gains have to be humongous this year, with Treasury yields plunging from 4% to
1.38% in the last two years alone.

This takes me back to the Golden Age of hedge funds during the 1980's. For a start, you could count the
number of active funds on your fingers and toes, and we all knew each other. The usual suspects
included the owl like Soros, the bombastic Robertson, steely cool Tudor-Jones, the nefarious Bacon, the
complicated Steinhart, of course, myself, and a handful of others.

The traditional Wall Street establishment viewed us as outlaws, and believed that if the trades we were
doing weren't illegal, they should be, like short selling. Investigations and audits were a daily fact of life. It
wasn't easy being green. I believe that Steinhart was under investigation during his entire 40 year career,
but the Feds never brought a case.
It was worth it, because in those days, if you did copious research and engaged in enough out of the box
thinking, you could bring in enormous profits with almost no risk. I used to call these "free money" trades.
To be taken seriously as a manager by the small community of hedge fund investors you had to earn
40% a year or you weren't worth the perceived risk. Annual gains of 100% were not unheard of.

Let me give you an example. In 1989, you could buy a leveraged warrant on a Japanese stock near
parity, for $100, that gave you the right to own $500 worth of stock. You bought the warrant and sold
short the underlying stock. Overnight yen yields then were at 6%, so 500% X 6% = 30% a year, your risk
free return. Most Japanese stock dividends were near zero then, so the cost of borrowing was almost
nothing. If the stock then fell, you also made big money on your short stock position. This was not a bad
portfolio to have in 1990, when the Nikkei stock index plunged from ¥39,000 to ¥20,000 in three months,
and some individual shares dropped by 80%.

Trades like this were possible because only a smaller number of mathematicians and computer geeks,
like me, were on the hunt, and collectively, we amounted to no more than a flea on an elephant's back.
Today, there are over 10,000 hedge funds managing $2.2 trillion, accounting for anywhere from 50% to
70% of the daily volume.

Many of the strategies now can only be executed by multimillion dollar mainframe computers collocated
next to the stock exchange floor. Winning or losing trades are often determined by the speed of light. And
as the numbers have expanded exponentially from dozens to hundreds of thousands, the quality of the
players has gone down dramatically, with copycats and "wanabees" crowding the field.

The problem is that hedge funds are no longer peripheral to the market. They are the market, and therein
lies the headache. How are you supposed to outperform the market when it means beating yourself? As a
result, hedge fund managers have replaced the individual as the new "dumb money, buying tops and
selling bottoms, only to cover at a loss, as we witnessed today.

The big, momentum breakout never happens anymore. This is seen in hedge fund returns that have been
declining for a decade. The average hedge fund return this year is a scant 2.2%, compared to 13% for the
S&P 500. Fewer than 11% of hedge fund managers our outperforming the index, or a simple index fund.
Make 10% now and you are a hero, especially if you are a big fund. That hardly justifies the 2%/20% fee
structure that is still common in the industry.

When markets disintegrate into a few big hedge funds slugging it out against each other, no one makes
any money. I saw this happen in Tokyo in the 1990's, when hedge funds took over the bulk of trading.
Volumes shrank to a shadow of their former selves, and today, Japan has fallen so far off the radar that
no one cares what goes on there. Japanese equity warrants ceased trading by 1994.

How does this end? We have already seen the outcome; that investors flee markets run by hedge funds
and migrate to those where they have less of an impact. That explains the meteoric rise of trading
volumes of other assets classes, like bonds, foreign exchange, gold, silver, and other hard assets.

Hedge funds are left on their own to play in the mud of the equity markets as they may. This will continue
until hedge fund investors start departing in large numbers and taking their capital with them. The
December redemption notices show this is already underway. Just ask John Paulson, who has one of his
funds down 20% year to date, again.

By: Mad Hedge Fund Trader

White Papers
Pension Fund Evolution of Hedge Fund Investing

(source: http://www.agecroftpartners.com/papers-pension_fund_evolution.html) Agecroft
Partners LLC

Agecroft Partners predicts that pension plans will significantly increase their
exposure to mid-sized hedge funds over the next 10 years. The pension fund
industry is in the process of a major evolution in its use of hedge funds that
has implications on what percent of their portfolio they allocate to hedge
funds and how they achieve their hedge fund exposure, which will have
profound implications for mid-sized fund managers. The pension fund
industry has a very glacial approach to changes in asset allocation which can
take a couple decades to fully implement across the industry. Although
pension funds asset allocation trends are slow to develop, they tend to be
very strong and consistent.

To better understand this phenomenon, it is instructive to examine the
example of pension allocations to international securities beginning in the
mid-1980s. In the early 1980s, almost 100% of U.S. pension plan assets
were invested in U.S.-traded securities. It was viewed as imprudent and
highly risky to invest in non U.S. based securities, despite the strong
academic evidence that diversifying outside the U.S. could enhance returns
while reducing volatility. The process of U.S. pension plans diversifying their
portfolios with investments based outside the U.S. began with a few very
large and high profile pension plans adding international equity as a
component of their asset allocation. Initially, they limited that exposure to
1% or 2% of their total assets, even though their asset allocation models
suggested an allocation in the mid-20% range. This cap was slowly
increased every few years until allocation levels in the 20% range were
achieved over a 10 to 20 year period. The largest, most high profile pension
plans tend to follow the lead of the largest endowment funds, but act as first
movers in the pension industry. Mid-sized pension plans typically follow the
lead of the larger funds a couple years later, which is repeated yet again by
the smaller pension plans several years after that. This trickle down effect is
one reason why investment decisions by CALPERS receive so much media
coverage: many of the decisions they make will slowly be replicated across
the industry.

A similar trend can be seen currently within the pension plan industry that
will benefit hedge funds. Ten years ago, the average pension plan allocation
to hedge funds was less then 1% and only a very few corporate pension
plans had an allocation to hedge funds, with some of the first including
General Motors, General Electric, and Weyerhaeuser. In 2001, CALPERS
became the first public pension plan to allocate directly to hedge funds.
Since then, we have consistently seen an increase in the percentage of
pension plans allocating to hedge funds and an increase in the average
percent of their assets allocated to this sector. This holds true even with the
financial meltdown of 2008 and the subsequent media coverage of Madoff
and similar scandals, because pension plans have observed that hedge fund
indices have outperformed the long only benchmarks they use to evaluate
how their assets are performing.

Agecroft believes that overall approximately 5% of pension plan assets are
invested in hedge funds and pension plans which have approved an
allocation to hedge funds having an average of 8% of their assets devoted to
this sector. In a fully discretionary asset allocation model, with no
constraints, hedge funds would assign an allocation multiple times this
current level, which is where Agecroft believes the industry will gravitate
over time. The current pension allocation is only a fraction of the allocation
of many of the leading endowment funds, many of whom have up to 50% of
their portfolio invested in hedge funds.

The typical process most large pension plans follow to achieve their hedge
fund allocations begins with a very small initial allocation utilizing hedge fund
of funds. This is increased every few years as the pension plan increases its
knowledge of the hedge fund market place. At that point, the pension moves
to a second phase of investing directly in hedge funds with assistance from a
consultant. An overwhelming majority of the hedge funds a pension plan will
invest in at this stage of the process are the largest, “brand name” hedge
funds with long track records. Performance is of secondary consideration to
perceived safety and a reduction of headline risk. A vast majority of pension
plans that have a hedge fund allocation are currently in these initial two
phases. After a few more years of making direct investments in hedge funds,
pension plans move to the third phase and begin to build out their internal
hedge fund staff, which shifts the focus from name brand hedge funds to
alpha generators. These tend to be more midsized hedge funds that are
more nimble. In a study conducted from 1996 through 2009 by Per Trac,
small hedge funds outperformed their larger peers 13 of the past 14 years.
Simply put, it is much more difficult for a hedge fund to generate alpha with
very large assets under management. Many hedge funds do limit the
amount of assets they will accept for a particular strategy, but there remains
a large financial incentive to grow the fund above its optimal size in light of
the strategy. There are other hedge fund organizations that are morphing
into large asset gathers and will grow their funds significantly above optimal
levels, at times changing their investment process or type of securities
traded in order to accept more investor assets. The fund at some point may
bear little resemblance to what it looked like during earlier days when it was
able to achieve strong investment returns. There is surprisingly little focus
by investors on determining capacity constraints for individual hedge funds.
Many investors limit their due diligence on this important question to an
interview of the manager, who has a conflict of interest.

The pension industry is slow to move, but will gravitate over time to
enhancing the risk adjusted returns of their portfolios. This is exactly the
process they followed in the late 70s and early 80s after The Employee
Retirement Income Security Act (ERISA) was passed by Congress in 1974,
requiring all pension plans to prefund their liabilities. At that time, 90% of
pension plan assets were invested with large banks, insurance companies
and brokerage firms. The top 10 managers of pension plan money were
large brand name firms like Prudential, The Travelers, Metropolitan Life, and
Equitable. However, pension plans soon realized that these large
organizations were not able to generate the same returns as their smaller
independent competitors focusing on niche strategies. As a result, the 1980s
saw a huge shift away from the brand names to smaller independent firms.
This same shift will also take place with hedge funds. This is the process
many of the largest endowment funds experienced. These endowment funds
began making direct hedge fund investment in large brand name funds, but
as their sophistication with hedge funds increased, they increased their
allocation to smaller and mid-sized mangers. Agecroft also believes that
some of the largest pension plans will adopt a hub and spoke approach to
hedge fund investing, in which the hub of their hedge portfolio will be in the
largest hedge funds to gain exposure to the “asset class,” while the spoke
will be invested in smaller, high alpha managers.

The final step of this evolution will occur when pension plans stop viewing
hedge funds as a separate asset class and instead allow hedge fund
managers to compete head-to-head with long-only managers for each part
of the portfolio on a best-of-breed basis. Many of the leading endowment
and foundations have evolved to this point: their portfolios are primarily
invested in alternative managers, with large allocations to midsized hedge
funds. This allocation strategy is now being called the “endowment fund
approach” to managing money. Historically, the large endowment funds
have been many years ahead of pension plans in implementing new
strategies and as a result have significantly outperformed their pension plan

Agecroft is not predicting that pension plans will only be allocating to mid-
sized hedge funds. What we are predicting is that over the next 10 years we
will see a significant increase in the percentage of pension plans investing a
meaningful percentage of their hedge fund portfolio away from the largest
managers to small and mid-sized managers. This evolution is not necessarily
a negative for fund of funds or large brand name hedge funds, because the
business they lose from their clients evolving to the next phase of the hedge
fund allocation process will be offset by a significant increase in the number
of pension plans making their initial allocation to hedge funds, as well as a
significant increase in the average pension plan asset allocation to hedge

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