1. An alternative Christmas card
Opalesque Alternative Market Briefing, 30 November 2011
http://www.opalesque.com/639673/An_alternative_Christmas_card967.html
By Drago Indjic, Sunningdale Capital's co-founding partner and Project Manager at the London Business
School:
It appears that Christmas came early for all underperforming funds offering longer than "monthly + 30
days notice" redemptions. Tomorrow, the last window of opportunity to redeem hedge funds will be
closed and since major broad hedge fund indexes are expected to be in "high single digit" negative
territory, many will say that 2011 calendar year losses have been inevitable.
Are managers still rewarded for pursuing "absolute" returns? Regardless of type of explanations for
losses, many discussions will involve "relative" performance against investable indexes and/or peers. In
particular, diversified FoHF performance will have to be compared principally against the broad hedge
fund market. There is little need for verbosity on probable causes of losses since here we are looking for
treatments: have investors had access to any cure?
It is recognised that the third quarter of 2011 was one of the worst ever quarters for hedge funds.
Obviously, most losing FoHF followed the market wide losses through their natural "long" market
position. We should accept that investing in hedge funds does not guarantee absolute returns. In
addition, most managers had the benefit of the relatively fresh experience of September 2008 and the
opportunity to adopt to survive the next crisis. Moreover, market instruments and liquidity evolved:
Exchange Traded Funds and similar products will probably overtake hedge funds in terms of size
sometime next year.
Not being very different from the market – and in practice a typical diversified FoHF will find it difficult –
implies exhibiting effective hedge fund market Beta uncomfortably close to one. If only this unwanted
and highly damaging Beta exposure could have been avoided, 2011 would be a happier year for many.
The glaring "missing trade" was to be short hedge funds starting from May 2011. This single
discretionary trade – or risk management action - could have been taken to stop losses. Regrettably,
many FoHF still ran with excessively long duration of their portfolios and thus were unable to take any
specific action to avoid losses, in stark contrast with end investor demands to follow formal risk policies.
As equity volatility continued to be high since Q3 and trends were punctuated by sharp reversals, hedge
fund market Beta easily obscured and damaged any residual outperformance, preventing delivery of
hedge fund product Alpha relative to hedge fund market Beta.
The short trade could have been implemented using modern index products. Being long hedge fund
market index in a single trade was possible for over five years and became increasingly commoditised
through the launch of new UCITS and ETF products. The hedge fund index replication can be hardly any
news: Opalesque media covered many alternative Beta opinion leaders: Lars Jaeger (May 2010),
Narayan Naik (September 2010) and Christof Schmidhuber (September 2011). There are a few dozen

2. alternative Beta purveyors offering index products of all shapes and forms and similar to modern ETF
product ranges, alternative Beta index exposure can be obtained in derivative and reverse form. By
virtue of alternative Beta taking form of index products and securities, there are additional oft-quoted
benefits: fixed cost, no operational risk, transparency, daily and better liquidity, to name a few.
Since all required components for protecting downside and improving liquidity existed, it is becoming
harder to rationalise avoiding using them in the best interest of investors or not acquiring necessary
additional skills and strategies. Notably, demand for specific skills traditionally aspiring to seek Alpha that
would not guarantee performance delivery will change (becoming commoditised through outsourced
operational due diligence, manager selection advisory etc): indexes are not Alpha but specific, tradable
risk premiums. If not available in-house, additional skills can be found in independent specialist firms,
academia or even offered by product vendors. In essence, 2011 and beyond cannot be navigated
successfully by using old, "buy and hold" hedge fund products.
Let us imagine that instead of performing a single discretionary trade in Q3 we would like to exploit
alternative Beta risk premium, in conjunction with "core" underlying investment strategy or product
targeting specific risk profile. Today one can respond to hedge fund market conditions accordingly –
decide to follow the market direction or not - even daily and intra-daily if required. In the simplest
consideration, one is not forced to be long hedge fund market continuously. Yet there is no imminent
need to demand full transparency of the underlying portfolios and then "micro-hedge" all possible
residual Betas all the time. Therefore, the starting point can be to understand the admissible alternative
Beta "budget" of your product (an aspiring Alpha source), its liquidity and to contrast it with the
alternative Beta style currently rewarded in the market. Moreover, as hedge fund market risk premium
has a life on its own, one can consider systematic exploitation of structural inefficiencies.
Hence looking at hedge fund market performance from May 2011 onwards and being short the hedge
fund index could have been such an easy trade. Even a purely directional view or a simple momentum
model could have created value. Now consider that we can start analysing various alternative Beta
cycles and styles, looking for new frontiers of exploiting hedge fund market inefficiencies. This may even
require additions a new strategy definition. If used "naked", these strategies would directly exploit
evolution of market alternative Beta premium, or if used together with other hedge fund underlying, could
address deficiencies in risk budgets and formal risk policies. There is no need to bias the active selection
of hedge fund managers or to start second guessing their actions. The objective is to make portfolios of
hedge funds better – and over 50% cheaper as it avoids "2/20" cost of exposure to pure market Beta
opportunities – thus enabling filtering of "non-Alpha" components.
Using index products for discretionary trading and risk management is straightforward. However, if
"naked" alternative Beta investment strategy is expected to deliver Sharpe ratios over one in disciplined
trading, additional skills are required. Our research has demonstrated the feasibility of producing
sustained annualised performance of 10%+ with high Sharpe ratio by doing only a few monthly trades
systematically (see Chart). There is a significant scope for improvement. Beyond "varying" hedge fund
market Beta, strategies can temporarily include "tilted" exposure to a different alternative Beta style, like
systematic CTA Beta.

3. Unlike Alpha capacity that may be limited and costly, the replication capacity can be continuously
increased, reflecting demand, and reduced trading spreads will follow. Investment banks will create as
much capacity as investors demand. If the size of market of passive Beta opportunities is today matching
the size of Alpha hedge fund opportunities, why limit yourself to searching for needle-like Alphas from
hedge fund haystack (as everybody else does) rather than actively dealing with obvious Betas?
I have been lucky to participate in the young days of both FoHF and alternative Beta development and
remained a believer in their successful marriage. Investors can lose patience with FoHF for the second
time after 2008 and demand only those exhibiting Alpha above the hedge fund index. Just operating in
the "average" – as classic diversified FoHF keep doing – delivers Beta only and misses delivering
valuable (socially beneficial) genuine FoHF functions in seeding and secondary markets. Over time,
markets remove inefficiencies and push the bar upward: in 2012 we will be closer to long/short
alternative Beta products that will be able to outperform a significant portion of FoHF universe and long-
only index position than ever before. How would underperforming FoHFs explain to investors losses that
results from Beta management inactivity?
Like traditional Beta, alternative Beta products are here to stay: waves of financial innovation and
Exchange Traded Products are unstoppable. The New Year resolutions may include: FoHF adding Beta
"seasoning" to improve product performance, the end investors considering alternative index strategies
and hedge fund managers thinking about becoming pure Alpha source or satellite on top of the core,
variable bias alternative Beta.
Drago's recent interview on Opalesque Radio:Source
Referenced in 9 January briefing by Bailey McCann, Opalesque New York:
http://www.opalesque.com/640140/Alternative_beta_products_can_provide_returns_even014.html

4. rd
[Figure comment – not included in the original article] Simulated fully systematic trading of basket of 3 party
hedge fund replicators (black) vs HFRX Global index (red). Blue shaded periods denote reverse exposure to hedge
fund market. Together with discretionary risk management, a similar systematic model has been used in real-time
simulated and reported trading trial within Sunningdale Alpha Fund, a hybrid fund of HF and replicators between
January 2010 and December 2011 (closed). The strategy is today available only in managed account format.
Source: Sunningdale Capital