Morningstar Advisor - December/January 2010 - 44

Morningstar Conversation John Maynard Keynes said, ‘In the long run, we’re all dead.’ But I think that a hedge fund manager added, ‘Make sure the short run doesn’t kill you first.’ Being able to generate returns in a risk-controlled environment is the main lesson that we’ve learned from the hedge fund industry. Andrew Lo What we’re doing in the mutual fund space is different from Andy’s approach. We are more bottom-up. We’ve been doing arbitrage strategies, convertibles, mergers for many years. We’re building the strategies to be costeffective and liquid. Given the leverage and shorting constraints, it’s a pretty conservative fund. It’s a fund that we think will generate 5% over cash over the long term with very low correlation to equity markets. So far, so good. NP: Andy, do you think that there’s a difference between investing in hedge fund strategies, as Cliff does, and trying to replicate the aggregate strategies, as you do? AL: There are certainly differences. For CA: I think the answer is twofold. The number-one reason is to make money over time. If you don’t have a positive expected return to what you do, all the diversification in the world, unless it’s wonderfully cheap insurance, is not worth it. gains and protect from losses is not as costly as you might think. AL: That makes a lot of sense. John Maynard example, in the approach that we take, we use only liquid futures and forward contracts, and that’s good in the sense that we provide our investors with that kind of liquidity and capacity. But one of the things that we don’t get that you get with Cliff’s approach is some of the illiquidity premium that comes with investing in a bottom-up approach. For certain investors, that’s a very good source of additional expected return that they’re not going to get from a futures strategy. CA: So, a pretty good approach would be for The second reason is to provide diversification and to cut risk. Risk management is an important part of hedge funds. There are two ways to do that. The first is by design. You have strategies that are hedged, that are relative value strategies, long something and short something—where you think you have some reason why the longs are going to do better than the shorts. This is not necessarily about dynamically managing risk. It’s more about construction and how you can create a naturally low correlated set of strategies. The second way is doing some risk control on the fly to limit the downside. Without knowing the details, because he won’t send me the computer code, I’d bet Andy’s approach includes what a lot of hedge funds do, which is some form of controlling losses, some form of risk control. That’s very common in the hedge fund world, and I had to become a believer of this over time. I started out early in my career thinking anything that looked like a stop-loss was a sin, that you’re always supposed to take the same amount of risk. I now think that being alive is a good thing and being able to limit losses and create a risk profile for a client is not very costly to a portfolio. Assets tend to trend more than they tend to reverse, and therefore, trying to lock in some Keynes said, “In the long run, we’re all dead.” But I think that a hedge fund manager added, “Make sure the short run doesn’t kill you first.” Being able to generate returns in a riskcontrolled environment is the main lesson that we’ve learned from the hedge fund industry. There are a number of very important aspects of how a hedge fund manager approaches investments that long-only managers don’t have to deal with. In the world of long-only investing, you’ve got a benchmark and your objective is to beat that benchmark. With hedge funds, the objective is to generate returns for investors. It’s much more openended; you have much more latitude. But, therefore, you have many different ways of hanging yourself. The alternative universe provides us a variety of mechanisms to generate those returns, but you have to worry about a much broader set of risks as well. NP: Why not simply use government bonds for diversification? As was mentioned, they were the best-performing asset in 2008. CA: That’s a great question, and the answer investors to give half their money to Andy and half to me (laughter). Earn a Return, First and Foremost NP: So the real reason for having an alternative investment in your portfolio is to actively change the risk profile. Is that correct? gets back to that expected return part of a portfolio. Government bonds are quite exciting from a diversification perspective. They’re great diversification during times of panics. But there are states of the world where even 44 Morningstar Advisor December/January 2010

Morningstar Advisor - December/January 2010

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