With the increase in the amount of hedge funds under management as well as the high demand for investors in this type of investment, a new company is launching itself into constructing and selling an IT platform designed to construct traditional portfolios and funds of hedge funds: HFOptimizer platform.
- What is behind the concept of HFOptimizer's platform?
The concept was born when my thesis won an award from a Swiss bank for the best university project of 2000. The concept is based on minimizing extreme negative returns. In 2001 and 2002, I developed this model in Visual Basic purely for academic reasons. In 2002, one of my articles, "Modified Value-at-Risk Optimisation with Hedge Funds" achieved real recognition. In 2003, I was invited to conferences to present my idea on extreme risks. In 2004, the EDHEC Business School stressed that optimization using Modified Value-at-Risk was a useful technique for reducing extreme risks. In 2003 and 2004, this Visual Basic model was used by UBS Wealth Management to help construct its funds of hedge funds. Realizing that the bank's internal demand for this kind of model was high, I decided to found AlternativeSoft LLC in June 2004. The objective was to offer investors an IT platform that combines the portfolio construction methods of a large Swiss bank and the latest academic models.
At this point, I had to recruit motivated programmers who were quick and had cutting-edge knowledge of statistics, whom I found in Russia. In terms of the academic model that makes our platform attractive, they are derived from working papers (i.e. Conditional VaR minimization), books on hedge funds (i.e. The Sharpe-Based Style Analysis) and our own research (i.e. Four Moment CAPM pricing). The greatest challenge was creating a fast optimization algorithm that resolved nonlinear functions, extreme risk functions. We obtained rapid and precise calculations even for portfolios with 200 assets.
I hope the combination of these three factors-quick programmers, academic models and fast calculations-are going to ensure the success of our platform. To increase the chances of selling our IT platform, we have surrounded ourselves with financial advisors.
Every bank has its own system of constructing portfolios or funds of hedge funds. One of our objectives is to free our clients from systematically using Excel , Matlab , Solver , E-views , etc. to construct their portfolios. All in one platform, we have put a precise optimization tool, a model designed to select funds and construct portfolios and a tactical asset allocation model in order to save time and generate superior performance.
- What risk management services does AlternativeSoft LLC offers its clientele?
Currently, AlternativeSoft LLC is offering its IT platform to banks and financial institutions. Our clients want to take advantage of the latest quantitative academic models for choosing hedge funds, constructing portfolios and forecasting index returns. We believe that consulting in forecasting hedge fund index returns has a bright future, the same future as traditional tactical allocation has had for 10 years. Given that it is possible to forecast monthly returns on hedge fund indices (see, for example, Amenc, El-Bied, Martellini, Evidence of Predictability in Hedge Fund Returns and Multi-Style Multi-Class Tactical Style Allocation Decisions, 2002), investors will be tempted at some point to utilize tactical allocation of hedge fund styles. Investors will have the choice between purchasing our platform or using our consulting services to make forecasts. This consulting service offered by AlternativeSoft LLC should be very successful in 2005.
- As a bank or as a fund of funds, why should I purchase or switch to your platform?
Our platform is interesting for three main reasons. The first reason is that our platform will allow you to understand the effects of extreme risk on the optimal wealth of a portfolio. Imagine that average variance isn't the right measure for constructing portfolios, including hedge funds-your company would take a high operational risk. Secondly, our platform will be useful to you if you think that quantitative analysis is as important as qualitative analysis in choosing hedge funds and constructing funds of hedge funds. Thirdly, you can use our platform on your laptop while meeting with a private client or a pension fund because we have built a platform that is easy to use. Currently, our clients are funds of hedge funds in the process of growing that do not yet have the infrastructure to hire several hedge fund analysts, funds of hedge funds managed by academics who think that quantitative analysis is as important as qualitative, or by banks that are branching into managing funds of hedge funds. This shows that our platform is useful to institutions without a broad infrastructure that want rapid growth without having to hire a lot of analysts.
- How has risk management evolved and how do you see the changing in the future?
As aforementioned, I think that hedge fund risk and funds of hedge funds will increasingly be measured by using extreme measures like Value-at-Risk, MVaR, CVaR, Omega or skewness. In the future, someone who invests in hedge funds and structured products should focus more on these extreme measures than on volatility.
- How can technology help performance?
Like in many hedge funds like CTA strategies, fixed-income arbitrage or statistical arbitrage, technology helps manage a faster decision-making process. I think this is also the case in constructing funds of hedge funds where it is possible to extract from historic returns, the default probabilities. In 2005, we will attempt to integrate in our platform a model that would give probabilities of hedge fund manager fraud. We will add as well a hedge fund rating in our platform. This will partly replace lengthy due diligence processes.
- How can clients benefit from using your platform as compared to traditional platforms available on the market?
In our platform, the client benefits from the latest academic models for choosing and constructing hedge funds and forecasting returns. The platform is dedicated almost exclusively to hedge fund investment. Thanks to this platform, the user of our platform obtains added value by quantitatively justifying his/her selection, by constructing funds of hedge funds with little negative extreme risk and by improving returns on his/her fund with tactical allocation.
The differences between our platform and the other platforms are the following. Our platform includes normal and non-normal portfolio simulation. To construct portfolios and fund of funds, our optimization minimizes the probabilities of extreme negative returns. Our platform exhibits the portfolio shortfall risk (i.e. the probability to be, in the future, below a certain target return). Our platform is doing portfolio stress testing with respect to the selected desired benchmark. Our platform ranks the hedge funds based on their styles and extracts the hedge fund's alpha. Finally, our platform forecasts the hedge fund, stock and bond indices returns by using an economic model.
Our competitive edge is our speed in setting up new academic models. In August 2004, a Finnish pension fund asked us about correcting hedge fund returns for autocorrelation, which we did a month later in the September 2004 release.
- What is the most important for you: manager selection or asset allocation?
In the past, manager selection was the main activity in a fund of hedge fund. In the future, with the advent of platforms like Lyxor, asset allocation or style selection is going to gain importance in the investment process of a fund of hedge fund. With the growth in the number of investors and the strong demand for diversified funds, those with a good diversification technique and a tool for forecasting returns will outperform those only concerned with manager selection. This phenomenon will be just like what happened to traditional portfolios, where asset allocation (market selection or sector selection) contributes more to performance than stock selection.
- How do you see the hedge fund market developing over the next few years?
In 2005, I imagine an exponential demand for funds of hedge funds from pension funds, but also from retail clients. The number of hedge funds will continue to increase. Average returns should decrease in 2005 and 2006, given the growing number of new hedge funds. A consolidation will occur in 2006 in order to take advantage of economies of scale. Like after all consolidations, average returns on hedge funds should rise again in 2007. It is important to see that hedge fund returns are linked to inefficiencies that people try to capture.
- How will your platform evolve to address those issues?
AlternativeSoft LLC and its HFOptimizer platform will continue to develop in 2005. We hope to hire new collaborators. We will integrate a new optimization model that will combine hedge funds with traditional portfolios. We will integrate optimization using the Omega coefficient. We will improve the hedge fund style selection model so our clients can generate returns greater than the indices. Our clients can look forward to a new version of the platform every four months.
This interview first appeared in Alternative Market Briefing at www.opalesque.com.