Regulation could be an opportunity for the fund of hedge funds industry to attract investors again

Funds of hedge funds have a role to play in institutional investor portfolios but they need to adapt their value proposition. Regulation could help the FoHF industry make its voice audible.

The implementation of the granularity adjustment, first introduced in the Basel framework, makes it possible to take the diversification potential of funds of hedge funds (FoHFs) into account and in turn to reconcile the outcome of the standard formula in Solvency II with empirical evidence.

With the severity of the recent financial crises, systemic risk issues have resurfaced for the first time in many years. It is no surprise to see a wave of new regulations and regulatory proposals on the ­financial markets.

Regulation can make financial markets more effective but it can also lead to additional costs and in some cases be seen as a source of risk by practitioners. In the hedge fund world, where regulation has mostly been lenient and investment flexibility provides a clear edge in the search for alpha, regulatory developments will have a strong impact, especially since the performance of both hedge funds and funds of hedge funds is being challenged.

While FoHFs were resilient after the bursting of the tech bubble, they suffered considerably in the financial crisis. Apart from a strong beta-driven rally in 2009, they have been struggling to perform since. As a result their aggregate assets under management (AUM) are still materially off the peak, even though single hedge funds have already reached new highs.

The additional regulatory burden could well be the straw that breaks the camel’s back for many FoHF managers, with some commentators predicting the ultimate demise of the FoHF industry.

However, regulation could actually be an opportunity for the FoHF industry. In the area of European insurance regulation we have shown in previous research that the standard approach laid out in the Solvency II directive does not properly calibrate the risk for FoHFs. Applying an internal model approach found that a stress test of no more than 25%, as opposed to 49%, is appropriate for a well-diversified hedge fund allocation. But many insurers will not have the capacity to deviate from the standard formula.

Therefore, building on Darolles and Vaissié (2012b), it is appropriate to propose an amendment to the standard formula that is inspired by the Basel framework and makes it possible to take into account the diversification benefits of FoHFs. The calibration of FoHF risk obtained with the granularity adjustment we recommend is consistent with empirical evidence.

As shown in previous research (Vaissié (2012)), the standard formula in Solvency II is mis-specified and overestimates the risk inherent in hedge fund investing. A suitable calibration for a diversified hedge fund allocation (for example, 25%) can be obtained with an internal model approach. But insurance companies with limited resources will have no choice but to stick to the standard formula.

As suggested in Darolles and Vaissié (2012b), a more appropriate action is implementing the granularity adjustment in order to take into account the diversification benefits of FoHFs and in turn reconcile the outcome of the standard formula with ­empirical ­evidence.

Any prudential framework involves a trade-off between simplicity and complexity. A basic classification of risks is likely to bring clarity but it will probably not lead to a good understanding of risks since each category is ­somewhat ­heterogeneous.

The ‘other equities’ category in the Solvency II framework is a perfect illustration. A detailed classification should lead to a better understanding of the different facets of risk but it may also create ­confusion.

In an attempt to integrate the complexity of risks within a simple framework, it is possible to build on Gordy (2003) and propose implementing a risk disaggregation technique that disentangles the common part of risk from the idiosyncratic component. By doing so it is possible to identify different sources of risk within a specific category and analyse their ­dependence ­structure.

Risk factor model
For the sake of simplicity, the Linear Single Risk Factor Model introduced by Gordy (2003) for application in the Basel framework (for the mathematical details, please refer to Darolles and Vaissié (2012b)) has been selected.

The first term of the model captures the non-diversifiable effect of the systematic ‘equity’ risk on the portfolio. As a risk measure it neglects the impact of the risks associated with the ‘other equities’ for a portfolio of finite size.

The second term is referred to as the granularity adjustment (GA) in the Basel framework and measures the impact of the individual risks of the ‘other equities’ when the portfolio size is large but finite.

It could be argued that the linear single risk factor model is too restrictive to capture the complexity of risks and in particular potential cross-effects between the ‘other equities’ and ‘equity’ risks. However, as shown in Gagliardini and Gouriéroux (2010), any portfolio risk measure (not only the value at risk (VaR)) can be easily broken down as the sum of two components under a set of very general assumptions. For the sake of simplicity, this research only considers the linear case although the generalisation is technically possible.

Hedge fund strategies show different risk/return profiles. The same holds true for their stress levels and as a result for their potential solvency capital charge (Vaissié (2012)). Ignoring this diversity and considering hedge funds as a homogeneous asset class is, therefore, a critical error.

In an attempt to take into account the heterogeneity of hedge fund strategies and in turn the diversification properties of FoHFs, the research implements the granularity adjustment to hedge fund investments. The same approach would also make sense for other constituents of the ‘other equities’ category such as ­commodities.

Practical implementation requires the calibration of three parameters, namely the ‘equity’ systematic risk level (η), the additional risk associated with the ‘other equities’ (σ) and the sensitivity between the ‘equity’ and ‘other equities’ categories (β). Darolles and Vaissié (2012b) propose two approaches to calibrate them. They label those two approaches granularity adjustment 1 and granularity ­adjustment 2.

For granularity adjustment 1, they start with the solvency capital requirement (SCR) recommended by the regulator for the ‘equity’ and ‘other equities’ categories, namely 39% and 49%, and they calibrate the two risk parameters η and σ through a reverse engineering process. The confidence level is set to 99.5% in line with the regulator recommendation and β is assumed to be equal to one.

It is worth underlining that the latter assumption is more conservative than the regulator’s in the standard formula, since it is assuming no diversification potential at all between the ‘equity’ and ‘other equities’ categories.

To study the impact of the level of diversification on the capital charge, one simply needs to set different values for n, the number of portfolio constituents. As in figure 1, the stress level converges with exponential decay from 49% to 39% as n increases from one to 20.

In line with previous research (Henker (1998), Learned and Lhabitant (2004) or Brown et al (2011)) we observe that most of the diversification benefits are achieved with a limited number of constituents. It is important to bear in mind that it is the quality rather than the quantity that really matters when it comes to diversification (Darolles et al (2012)).

By making the assumption that part of the idiosyncratic component of the total risk can be diversified away at the portfolio level, the capital charge decreases mechanically. Even if one considers there is no diversification potential between the ‘other equities’ and ‘equity’ categories. However with granularity adjustment 1, the capital requirement for hedge fund investments is floored at 39%, for example the SCR of developed market equities.

In order to include the level of correlation between the ‘other equities’ and ‘equity’ categories in the analysis, Darolles and Vaissié (2012b) then relax the assumption β=1. The regulator proposes to use a correlation of 75%. They therefore use this value as a starting point to study the diversification effect.

Here again one simply needs to set different values for n to study the impact of the level of diversification on the capital charge. As it is possible to see in figure 1, the stress level converges with exponential decay from 49% to 30% as n increases from one to 20. Most of the diversification benefits are still achieved with a limited number of constituents.

In an attempt to finetune granularity adjustment 2, Darolles and Vaissié (2012b) subsequently take as an input the observed sensitivity instead of the one recommended by the regulator. They use the Lyxor Hedge Fund Index as a proxy for the hedge fund industry and the MSCI World Index as a proxy for the equity market.

For the capital charge to be conservative, they compute the betas on different rolling windows (figure 2), take the highest historical value and apply a haircut of 20% (in absolute terms). They therefore end up with a beta of 0.6. This approach is labelled granularity adjustment 2*.

In figure 1 this time the stress level converges with exponential decay from 49% to 25% as n increases from one to 20. This result backs up a previous study by Vaissié (2012) which shows that 25% is a suitable capital requirement for a diversified FoHF. Most of the diversification benefits are again achieved with a limited number of ­underlyings.


Investors regard the long-term risk/return profile of hedge fund strategies favourably. Alternative diversification has progressively become part of mainstream investment practices but many hedge fund investors only came on board at the top of the market.

Following the financial crisis, the performance of hedge funds and FoHFs has been disappointing by historical standards. Although there is some evidence in the academic literature that FoHFs add value over the long run (Darolles and Vaissié (2012a)), investors are questioning the rationale behind paying a double layer of fees.

Reinvention
In this context the challenge for FoHFs is to reinvent themselves at a time when various sets of new regulations are being introduced. Contrary to conventional wisdom, such a shift toward more regulation could turn out to be an opportunity for the FoHF industry, on condition that hedge fund investments are treated fairly.

The role of regulation is not only to control risk but also to trigger behavioural changes. In an environment in which institutional investors have to rethink their long-term investment policy and pay greater attention to risk management, prudential frameworks should give incentives to improve ­portfolio ­diversification.

With the current draft of the Solvency II directive, however, the regulator is merely encouraging a massive shift by insurers from equity-linked products to fixed income instruments, for example, exchanging one risk for another. The implementation of the granularity adjustment is an attempt to better calibrate the capital charge of FoHFs with the standard formula and make it possible for all insurance companies to leverage on alternative diversification.

In line with Vaissié (2012), we show that 25% appears to be a suitable capital requirement for a diversified FoHF. This is a very competitive capital charge compared with those of traditional performance-seeking assets.

Industry surveys suggest that some insurers are already inclined to increase their allocation to alternative investment strategies. Others might be forced to follow in order to control their funding ratio efficiently.

With regard to direct investment, only the largest insurers will have the capacity to manage customised allocations that are optimal from the investment and regulatory standpoints, notwithstanding the fact that monitoring and reporting costs might be dissuasive for many.

FoHFs, therefore, have a role to play in institutional investor portfolios but they need to adapt their value proposition. Regulation could help the FoHF industry to make its voice audible.

Mathieu Vaissié, research associate at Edhec-Risk Institute, wrote this article.

References
Brown, SJ; Gregoriou, GN and Pascalau, R (2011). Diversification in Funds of Hedge Funds: Is It Possible to Overdiversify? Working Paper, SUNY College at Plattsburg.
Darolles, S; Keller, S and Vaissié, M (2012). Diversification: It Is All About Quality, Not Quantity! Working Paper, Edhec-Risk Institute.
Darolles, S and Vaissié, M (2012a). The Alpha and Omega of Funds of Hedge Funds Added Value: A “Post” Crisis Analysis, Journal of Banking and Finance, 36(4): 1067-1078.
Darolles, S and Vaissié, M (2012b). Regulation: Threat or Opportunity for the Fund of Hedge Fund Industry?, in Reconsidering Funds of Hedge Funds: The Financial Crisis and Best Practices in Ucits, Tail Risks, Performance and Due Diligence, ed. G. Gregoriou/Elsevier, Forthcoming.
Gagliardini, P and Gouriéroux, C (2010). Granularity Adjustment for Risk Measures: Systematic vs Unsystematic Risks. Working Paper, CREST.
Gordy, M (2003). A Risk Factor Model Foundation for Rating-Based Bank Capital Rules. Journal of Financial Intermediation, 12(3): 199-232.
Henker, T (1998). Naïve Diversification for Hedge Funds, Journal of Alternative Investments, 1 (3): 33-38.
Learned, M and Lhabitant, FS (2004). Finding the Sweet Spot of Hedge Fund Diversification. Journal of Financial Transformation, 10: 31-39.
Vaissié, M (2012). Solvency II. Regulation Change and Hedge Fund Evolution. Journal of Alternative Investments, Forthcoming.