Alternative matters

A: They’re very complementary. My advice to someone who hasn’t gone through an MBA program is that they may want to get both designations. The CFA is a very strong generalist program for asset management. Our program is purely on the alternative space. Half of the members are fund managers. That’s a little bit skewed because some are fund of fund allocators so they’re allocating money but not managing the individual investments. About 30% are advisors and consultants and then the remainder are analysts and people on the secondary service side of the industry, fund administrators, lawyers and accountants, and a big area we’re working on is regulators.

Q: Given what markets have done over the past year, have you seen an increase or fall-off in applications?

A: We’ve seen it basically flatten. We had a pretty steep growth curve, which we knew was not going to last forever. But we flattened out a bit in the last cycle. My guess though is that, in time, there’s going to be a huge amount of regulatory change that comes into the market. There’s going to be a structural change in the market with financial institutions no longer necessarily playing the same role as they were playing before. Perhaps hedge funds and private equity [will] step in as lenders, taking over from the bank role.

Q: What constitutes the alternative space?

A: If you ask two people, you get two different answers – you ask three, you’ll get three different answers. The way we look at it – and the real purpose of the program is to cover everything outside of the traditional space – we put that into buckets: hedge funds, private equity, real estate, commodities and managed futures. But we cover more than that. We’ll cover timber as an asset class. We’re incorporating carbon trading now in the program – any new areas that are outside the traditional long-only equity and fixed income space.

If you go back two years ago and you surveyed MBAs coming out of the top universities around the globe, the two areas of most interest were hedge funds and private equity and yet their exposure to those areas maybe involved one or two courses. There is really no formalized university or academic structure to gain expertise in this area. That means it falls on the firms. That’s not their business. And it’s just as difficult for them to develop training programs as it is for the universities to develop appropriate courses. At the same time, we are encouraging universities and assisting universities in developing curriculum.

Q: Do you see some areas in the alternative space undergoing an expansion or a contraction because of the cycle they’ve gone through, or because of scandals, so that some institutions pull back from investing while others think of getting in because it’s no longer an overpriced boom?

A: For the larger institutions that have been involved in this area and have the internal resources, I don’t know of any that are planning to pare back on this area in general. They may be looking to expand now into areas that they consider more likely to produce non-correlated returns and continue to push that frontier.

I don’t see anybody pulling back in this space and frankly, if you look at what’s happened, why would you? Nobody’s happy with the returns on hedge funds in 2008. But I would argue that hedge funds were as much a victim as the investors were.

A lot of the things that contributed to the poor return performance in the hedge funds were outside their control. They were involved in subprime and clearly that was an area that was very difficult to manage and they got caught up with that, as the banks did. But if you look outside of that, if you look at the short-selling bans, if you look at Lehman and the problems that created for the funds that used them as their fund administrators and their prime brokers, there were a lot of losses created simply by various dislocations on the market.

Areas that offer tremendous value right now are – although, as you can imagine people are timid about being aggressive – on the credit side, especially in the distressed area. There’s going to be some very good opportunities going forward. I don’t think that anybody’s in a hurry, but I actually think that our industry, if we can call it that, may offer more of a long-term solution to the problems that we are facing with these toxic assets than anything else. Obviously, governments are going to try to do what they can to rehabilitate the banks’ balance sheets. If they were to create a toxic or bad bank, to channel all those toxic assets and get them off the balance sheet, that’s fine, but I also think that the private sector can play a big role.

Q: Who’s going to be best positioned to manage this paper, much of which will, in time, be profitable?

A: The problem is it’s not trading now. And nobody is willing to buy. That means you can’t put a price on it, you can’t do anything with it, you’re stuck, you’re frozen. But as you get more capital, for instance on the hedge fund side, the expertise to manage these securities – and just as important the capital to hold these securities until trading resumes – then I think they’re best positioned to begin starting those markets to be functioning again.

Q: And private equity?

A: Private equity, if you look at the past several years, they were buying into inflated assets. We don’t question that. Now they’re sitting on these positions and obviously the returns aren’t looking great. That’s what we call bad vintage years. But if you look at it from this point on, I think there’s tremendous opportunity there for basically the opposite reason: you have asset deflation taking place.

The opportunities for private equity are going to be fairly significant because of the dislocations we have seen. These will prove, over the next two or three years, to be very good vintage years.

Q: What about venture capital? News reports about the Silicon Valley are fairly gloomy.

A: Access to capital is an issue. The deals will be smaller. The time horizon will be a little bit shorter. It may make it a little less appealing for the large institutional investors because they’re always looking for longer-duration assets. But there will still be opportunities there.

Q: Is commercial real estate, for someone who’s well capitalized, an opportunity now?

A: It is, but I think you might want to give it a bit more time. It has lagged the retail market. So, I think there’s still some downside there. But there too, you’re getting people who are forced to liquidate their holdings, so you’re going to get some bargains out there if you have the capital to take advantage of it, and if you can position it more.

That’s the case with real estate. As long as you’re not a forced seller in real estate, you can generally do reasonably well. It’s just that you’ve got to watch the cycles.

Some of the numbers that you look at, not only on the commercial side, but also on the residential side – I’m speaking about the U.S. right now – some of the overhang is pretty significant.

Q: In a bear market, all correlations converge, even at the Harvard Endowment. Where can alternative investments add value?

A: There are non-correlated assets, but I also think that in times of crisis, when there are severe pressures in the marketplace, you do see all the correlations going to one. Everybody is in the same boat. To a certain extent, people have been disappointed that the returns were not better, that the absolute returns did not come through for the hedge funds in particular last year.

If you look at what caused the poor returns, a lot of it was driven by forced liquidation. A lot of anguish was generated by short selling. A lot of difficulty in managing positions arose out of Lehman’s bankruptcy. There are horror stories of people caught in positions where one side was cleared through Lehman and the other side of the trade was with someone else and they don’t know what to do with it now because they’re stuck. They can’t do anything on the Lehman side and they assume that they still own that paper, but that will probably take another year or two years to sweat out. What do you do with that trade? If you’ve got a matching trade on, do you liquidate the other side and just try to manage the one exposure? It’s a very dif- ficult position.

A lot of successful firms are down in assets under management because they were bankable liquidity for a lot of investors. So I’ve got losses all over the place, I’ve got to raise money or I’ve got a capital call with a private equity fund, I’ve got to raise that capital. Where do I go? I can’t go to all the funds where they’re losing money – they’ve closed the gates on me. I’ve got to go to the funds that have actually performed well, so they’ve got to hurry.

It’s difficult to manage when you get broadsided by that. You have gotten good returns, you expect that you’re going to continue to grow assets or at least retain them, and then the next thing you know you’re getting all these calls for liquidation.

Q: Do the events of the past year speak to the need, for the CAIA, of a more robust model of risk management?

A: I definitely think so. The whole approach to risk management is being rethought. And that’s a benefit out of the disaster that we’re in right now. People were relying too much on historical data to drive the risk-management models.

It’s going to be very challenging for our program to keep up with those developments. Getting back to your question about CAIA and the CFA, that is one of the biggest differences, which is the dynamic nature of the program we are attempting to cover versus a more mature, more developed industry in the traditional space.

People are going to look at their due diligence process and separate some of those functions more than they have in the past. They’re going to be looking for multiple prime brokers, independent fund administrators to address the concerns of the end investor.

There’s going to be some very significant structural changes in the regulatory environment and that has the potential to be very positive long-term. It’s going to be painful, there’s going to be mistakes and missteps along the way. So if someone were to ask me, am I in favour of regulation, I would say “absolutely.”

Q: What about changes, for example, in value-at-risk analysis?

A: I think there’s been, certainly on the quantitative side, too much of a reliance on using historical data to develop the models. I may not agree with everything that Naseem Talib says, but he certainly has a point. Clearly these events that we historically look at as a three to five standard deviation event are happening with more frequency. That being the case, the models have to be addressed to reflect that.

In normal times, you can assume normal relationships hold. You may vary at the margins, but you’ve got relationships that remain fairly constant. In abnormal times, they can change dramatically and if you look over your portfolio, very often there may be something you’ve built into it – not by design, but by accident – exposure to that normalcy of those relationships and not accounting for the fact of “what if everything goes to hell?”

Where am I exposed? If I’m relying on short-term borrowing for one of those strategies, how badly can that go wrong and what impact is that going to have on the rest of the investment portfolio? It’s very difficult for people, you can’t really predict it, what’s going to cause it, how it’s going to happen or even what’s going to unfold but you try to go through as many of those scenarios as you can and say, if there’s one assumption in my portfolio that I’ve made that is going to cause the most damage if it breaks down, what is that?

How secure are my lines of credit if I need access? There’s going to be a different approach to booking and relying on modelling and modelling alone in terms of asking those determinations.

Q: We’ve talked about Madoff: what could CAIA offer?

A: Anybody who went through that due diligence process appropriately would’ve come out saying “there’s no way I could invest with this guy. There is no transparency. I have no idea where these positions are. I can’t get him to verify – or anybody else to verify them.” Anybody else running a strategy similar to what he claims to be running says “I can’t generate those returns, I have no idea how he’s doing it.”

In fact, one of our advisory board members, who runs a successful fund of funds, did an interview with Madoff in 1997, and somebody asked him, “Are you thinking of allocating any funds to him?” and he said, “If I were to go to New York City today and I were to drop my wallet on the sidewalk and were then to come back three hours later, I would be more likely to find that money than I would with Bernard Madoff.”