In the past, alternative investment strategies (AIS), such as hedge funds and managed futures investing has been dominated by high net worth investors. They were willing to bear the disadvantages of the mostly illiquid and non-transparent but steadily returning investment strategies. Due to the attractive risk-reward characteristics of AIS as well as their low correlation to traditional asset classes, institutional investors are now expressing increasing interest in these strategies. But the fiduciary responsibility that comes with investing clients’ money has led to new standards for transparency, higher demand for liquidity and a strong focus on risk management. The objective here is to discuss transparency and liquidity of AIS investments within a multi-manager portfolio and demonstrate their importance to investors.

Transparency
There are three core principles of responsible and successful AIS investing:
o A complete understanding of the strategies and strategy sectors including risk factors and levels of the individual sectors. The goal is to achieve the appropriate level of diversification.
o A detailed examination of the individual trading adviser’s strategy and a thorough due diligence process (qualitative and quantitative). The investor should understand the strategic edge of the individual trading advisor, know the investment firm’s structure and examine key personnel.
o Continuous monitoring and risk management of the investment exposure: profit and loss, exposure and risk characteristics of the portfolio should be monitored and interpreted on a continuous basis.
Unfortunately, many of the investment vehicles for AIS available in today’s market present investors with numerous liquidity and transparency issues; the story of LTCM serves as an example (see below).
Transparency and detailed knowledge of the individual trading advisers have the merit of decreasing individual manager risk, for the following main reasons:
o Detection of previously unknown (or unrecognised) risks in the investment strategy.
oQuick recognition of style changes, undesired bets and too high leverage factors employed by the trading adviser (leverage control).
o Reliable performance measurement.
o Significant decrease of fraud probability.
Without daily transparency and the appropriate knowledge of the strategy, diversification of a multi-manager portfolio remains largely a guessing game with the tendency to allocate most money to the ‘stars of the past’.
Despite the growing investor awareness of the importance of transparency, there are three arguments frequently used against transparency to the level of position disclosure:
Firstly, that confidential position information reaches the market place thereby potentially threatening the effectiveness of the strategy if more players adopt it, and also by being actively traded against by certain market players.
Secondly, that investors lack the skill to evaluate the massive amount of information provided by the frequent availability of positions.
Lastly, the request for transparency will prevent investing with the best trading adviser within the universe of hedge funds.
For the first argument, one must consider who actually poses a threat to AIS trading advisers. This threat comes mostly from the dealer community and the proprietary trading desks within the large investment banks rather than from fund of funds managers or individual investors. Once hedge funds know who their investors are and what their intention for transparency is, they can set up confidentiality agreements which keep the investor from proliferating relavant information.
The second argument neglects the increasing expertise and capacity of multi-strategy fund managers. Once these portfolio managers understand the underlying strategy, detailed position downloads can be evaluated within the context of this knowledge. A large variety of tools and software packages for sophisticated risk management are nowadays available to access the benefits of this information.
There is no truth in the third statement. The statement that multi-manager portfolios focusing on transparency will be left with ‘second tier’ managers finds no factual support. Many high quality ‘first tier’ managers are willing to offer the desired transparency. We do not see any relationship between a trading adviser refusing to be transparent and the quality of their trading performance.
The more openly a trading manager discloses strategy, the more likely they are able to present a clear edge. The third argument is linked to some unfortunate and persistent misperceptions about AIS. Many investors regard AIS a secretive industry, judging successful individual trading advisers by their stellar past returns. Examples of secretive, non-transparent and, for certain periods of time, very successful strategies are LTCM, Quantum fund, Tiger and Niederhoffer, all of which failed spectacularly in the end. High past returns had been accompanied with high risk, which eventually led to failure. The reality of AIS investing is that most strategies systematically earn risk premiums and with a bit of effort are actually not difficult to understand. Investors must learn to look beyond past return and instead look at how and in what market environment returns have been achieved. Recent studies have also shown that there is little convincing evidence that winning funds repeat in a way that can be exploited.

A new investment paradigm
A new ‘transparency paradigm’ in AIS investing is characterised by detailed understanding of the individual managers’ strategies (including their risks), complete transparency of the positions and transactions of each individual manager, highest possible investment liquidity, systematic and continuous monitoring of open positions and active risk management of the investment’s exposure. The most efficient way to achieve transparency on the individual trading adviser level is through a managed account. State-of-the-art quantitative tools are further necessary in order to perform the task of risk monitoring and management more effectively (Value-at-Risk (VaR), scenario analysis, and stress testing).
The benefits of transparency cannot be fully exploited without meaningful liquidity at the level of the individual manager as well as the portfolio level. Open-ended multi-manager funds with redemption periods ranging from one to six months are numerously offered to investors. Furthermore, a number of closed-end funds wrapped as investment companies and listed on an exchange, have been set up. Investors face problems with both structures. For open-ended funds with monthly or longer redemption periods, the settlement of the investment expands over a significant time span. These settlement problems do not appear with an exchange-traded investment company, as the instrument can be traded on a daily basis. But, due to the lack of a broad market, these products are not traded very actively, which can lead to a significant discount in the trading value compared to the NAV (discounts of up to 30% are observed frequently).
Bank Hofmann in collaboration with saisGroup has recently launched the world’s first multi-manager fund of AIS offering NAV-based daily liquidity. The fund is based on managed accounts. This fund is as easy to buy and sell as any normal mutual fund which is a major innovation in the global AIS industry.
The increasing demand for AIS products from institutional investors and a generally higher level of investor sophistication renders the ‘black box’ approach (non-transparent and illiquid funds) more and more unsuitable. The possibilities of 100% transparency in a multi-manager fund are much better than is currently assumed by many AIS allocators and investors. Finally, transparency is not nearly as useful without the appropriate level of liquidity. We foresee a dramatic increase in demand for liquid AIS products.
Lars Jaeger is Managing Director at the saisGroup in Zug and Frank Ramsperger is Chief Investment Officer of Bank Hofmann in Zurich. Lars Jaeger will provide a more extended discussion on risk management issues for Alternative Investment Strategies in a forthcoming book published by Financial Times/Prentice Hall in early 2002

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