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Asymmetric Returns

The Future of Active Asset Management

by Alexander M. Ineichen
John Wiley & Sons 2007
352 pages

Leadership & Management
Sales & Marketing
Human Resources
IT, Production & Logistics

Asymmetric returns are those in which the gains are disproportionate to the
possible losses. The probability of profit is greater than the probability of loss.
The search for asymmetric returns will shape the future of asset management.
Hedge funds are absolute-return investment vehicles; they will be significant in
the future of the asset management industry.

Career Development

Traditionally, experts have measured investment risk rather than managing it.

Small Business

Hedge fund risk management is more subjective and less transparent than risk
control in traditional investing.

Economics & Politics

Intercultural Management

Investors must balance their desire for transparency against the fund manager's
need for freedom of action.

Concepts & Trends

Weak assumptions, including the efficient-market hypothesis and modern portfolio

theory, underlie conventional wisdom about the market.
Particularly skilled investment managers can discover and exploit alpha, highlevel returns.
Active managers use a broad set of skills to discover opportunities and manage risk.
These skills are rare, come only with experience and are understandably expensive.

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This summary is intended for the use of CFA Institute members and employees

What You Will Learn
In this Abstract, you will learn: 1) What absolute-return investing is; 2) Why hedge
funds and the search for asymmetric returns may represent the future of the asset
management business; and 3) How to think about risk in the context of this financialindustry evolution.
The main theme of this dense book is the future of the asset management industry.
Alexander M. Ineichen claims that the investment business has undergone a paradigm
shift, away from buy-and-hold and toward absolute-return investing. He explores the
origins and implications of this shift in considerable detail and enjoyable prose. But,
beware, this is not a book for beginners or generalists. Even close students of finance may
find it difficult to follow the authors argument through his many detours and tangents
(interesting as they are). Ineichen is an ardent fan of high-risk, high-leverage hedge fund
investing, so his book will be controversial in the post-subprime-crisis atmosphere, where
that kind of investing has fallen from grace. Ineichen quotes John Maynard Keynes as
saying, When circumstances change, I change my view. What do you do? Published
in 2007, the book references the equity market bubble of 1995 to 2000 as the most recent
instance of large-scale market inefficiency, but getAbstract wonders whether the author
would change his view after the much more consequential financial collapse of 2008.

The argument of
this book is that
the absolutereturn approach
is the preferred
philosophy and
that asymmetric
returns are the

If all risks were

neutralized, so
would be the
returns. As Mario
Andretti put it: If
everything is under
control, youre
driving too slow.

Risk, Volatility and Asymmetric Returns

Michelangelo carved his David from a marble block that another sculptor had begun
to work on, but then discarded. Most people thought the block was no longer worth
anything, but Michelangelo saw something in it: the figure of David. He only needed to
free the figure from the stone around it. Similarly, positive alpha exists in the market.
Talented managers know how to carve away the superfluous risk to liberate this alpha.
Like sculptors, they need specialized tools to do so. For the most part, these are tools for
managing risk. Risks, as opposed to returns, are manageable.
To reap returns, investors must take risks. However, not all risks are equal. Some risks are
more likely to produce rewards than others. Asymmetric returns refers to investments
whose upsides are greater than their downsides. Their odds of earning a profit are
disproportionate to their odds of sustaining a loss. Only an active risk management
approach can discover and reap the benefits of such opportunities. In contrast, buy-andhold investors cannot realize asymmetric returns. They have exposure to both upside
gains and downside risk.
Traditional investment managers measure their performance using a benchmark. If the
benchmark falls, but the managed portfolio falls less, the manager has outperformed it
and, therefore, succeeded. Absolute-return hedge fund investors, by contrast, do not use
benchmarks. They do not succeed when they lose; they succeed only when they win.
Hedge funds have the advantage of allowing investors to increase their diversification
by using numerous separate portfolios. However, because they do not use benchmarks,
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feature of an
approach is
that it gives
priority to capital

transparency suffers. Traditionally, risk has been measured rather than managed. Risk
measurement is more or less objective and thus transparent, but it bears the danger of
purely rule-based management. Risk management, in contrast, is subjective. The
hedge fund business uses various approaches to risk management. As a general rule,
flexible dynamism is preferable to static dogmatism. Investors need to balance their
desire for transparency against the managers need for freedom of action.

Changes in Asset Management

The industry of asset management began to change structurally in 2000, at the beginning
of the new millennium. The year 2000 saw the beginning of a bear market. The drop
in stock prices focused investor attention on short-term volatility, and sharpened their
perceptions of risk.
The asset management business has been evolving in three phases:

For compounding
capital negatively,
no external help
is required. Most
investors can do it
on their own.

The year 2000 is

the turning point
at which hedge
funds started to
seriously compete
with the traditional
asset management
industry for

What has
changed is not
risk itself but
how investors
perceive risk.

1. Absolute return, little specialization Managers focused on asset allocation

rather than stock picking. This approach hit hard times in the 1970s, in part because
incentives encouraged managers to focus on outperforming their peers rather than
on making sound economic decisions.
2. Relative return, quite specialized Investors allocated assets, while specialized
managers managed the portfolios. Academic work, especially the hypothesis of
efficient markets, led to the creation of index funds and, in consequence, benchmarks.
3. Absolute return, quite specialized The metric is no longer a benchmark, but
rather a return target. This may reduce agency risk and eliminate safety-in-mediocrity
thinking, but it increases risk and the cost of selecting managers, because managers
are so diverse.
The search for asymmetric returns will characterize the future of the asset management
industry. Absolute-return investing, with its emphasis on preserving principal and
avoiding loss, will be an industry priority over the next two decades.

Risk Management Principles

Risk management tools allow managers to engineer risk/return situations that control
downside volatility and help reap asymmetric returns.
Nine principles govern risk management:

There is no return without risk Only risk takers can expect to reap returns.
Be transparent Risk should be clear and understandable.
Seek experience People manage risk; models dont.
Know what you dont know Test your assumptions.
Communicate Discuss risk.
Diversify This will allow more steady returns.
Show discipline Persevere and dont let passing events sway your judgment.
Use common sense Note that being about right beats being exactly wrong.
Return is only half the equation Think of return only in the context of risk.

Investors who entrust their funds to relative-return managers have a reasonably clear
idea of their asset allocations and market risks. Investors should not seek or expect those
advantages from an absolute-return manager. Their focus should be on the managers
risk-management skills, not on the risk-measurement scales. The successful risk manager
must be able to see when the risk/reward profile starts to shift, and must have a good
exit strategy and be able to implement it. This kind of skill is expensive and, until recent
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Hedge funds aim

for some sort of
asymmetry between
the probability of
making money and
the probability
of losing it.

absolute returns
to investors on a
sustainable basis
is difficult. It
requires active risk

investors cannot be
indifferent to shortterm volatility.

A 10-year
investment of $100
that is flat in the
first year and then
compounds at 8%
will end at $200. A
10-year investment
of $100 that falls
by 50% in the
first year and then
compounds at 8%
percent will end
at $100.

years, only a small fraction of investors put money into hedge funds. However, hedge
fund investing has become a great deal more popular. In the past, hedge fund managers
tended to be extraordinarily good risk managers. Increasing demand for hedge fund
investments may create opportunities for mediocrity that could threaten the shift to
asymmetric returns in the asset management industry.

The Price of Asymmetric Returns

Are hedge fund fees too high? They are, indeed, higher than mutual fund fees. However,
between 2000 and 2005, investors reaped much more wealth from hedge funds, even
after high fees, than they would have garnered from mutual funds. Investors pay absolutereturn managers to strike a balance between placing capital at risk and providing access
to opportunity. When the opportunities are rich, the manager may use leverage to put
more capital at risk. When the opportunities are lean, the manager reduces leverage and
puts less capital at risk.
Active management of total risk is not the same job as managing risk that tracks against a
benchmark. Success depends greatly on experience and a broad spectrum of skills. The
job of the manager is to see that the opportunity exists before the rest of the market sees
it, as well as to notice that the opportunity is disappearing before the rest of the market
notices. Managers with that kind of skill dont tend to advertise their methodologies or
tactics. They are too intelligent to show a winning hand to the other players at the poker
table. This makes it difficult for investors to find them, which increases the cost of
searching. Moreover, the scarcity of such managers and the benefits they bring to their
investors ensure that the price for their services will remain high.

The financial-services industry is anything but neat and tidy. After the dot-com bubble
burst, perceptions of risk changed. Until recently, the efficient-market hypothesis
and modern portfolio theory shaped the way most market participants looked at risk.
Many people believed that outstanding success at investing was a matter of random
luck. However, skill at managing risk and adjusting to change outweigh luck. A skilled
manager can use arbitrage to combat inefficiencies in the market, providing that the
problems are not too big such as the massive market inefficiencies of the 1995-2000
bubble. In such battles, managerial flexibility matters more than the market inefficiencies.
Absolute-return investing requires a high degree of adaptability.
Conventional wisdom is that risk decreases with time. Over long time periods, volatility
diminishes and returns tend to balance each other. However, the notion that long-term
developments will overcompensate for short-term volatility is faulty. A sharp drop in
one year can annihilate five years of capital compounds. Viewed from the perspective of
possible loss, time magnifies risk, because the potential for loss increases. The question
of whether time increases or decreases risk hinges on the definition of risk. Good risk
managers think probabilistically about risk. They recognize the uncertainty of knowledge
and question what they think they know.

Alpha and Asymmetry

Perfect market efficiency is impossible. It would eliminate the returns investors get for
researching and trading, and the markets would cease. Absolute-return managers do profit
from market inefficiencies. The efficient market hypothesis seems to be losing some of its
influence. The idea that skilled managers can reap excess returns is gaining credibility.
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Risk management
is at least as much
a craft as it is
a science.

Investors will encounter other unorthodox explanations of market behavior, though some
critics call these alternative approaches unscientific or voodoo science. Consider:
Praxeology This approach focuses on what human beings know a priori; it
denies the authority of observation and experiment as a means of discovering the
laws of economics.
Reflexivity In his approach, George Soros dismisses conventional assumptions
that the market strives for equilibrium, that perfect competition optimizes resource
allocation and that monetary and real phenomena are connected in a reflexive
fashion. Instead, Soros teaches that market participants expectations about future
developments shape market prices, which, in turn, shape future developments.

Most of academic
finance is teaching
that you cant
earn 40% a year
without some
risk of losing a
lot of money. In
some sense, what
happened is nicely
consistent with
what we teach.
[ William Sharpe
on the
LTCM collapse]

The four most

expensive words
in the English
language are
this time its
different. [ Sir
John Templeton]

Behavioral finance This methodology brings psychology to bear on the

explanation of anomalous and irrational behaviors in the markets. For example,
people tend to have more confidence in their own decisions than the facts justify.
They are more loss-averse than the mathematics of utility theory warrant.
Even if these theories contain just a grain of truth which some people ignore, they provide
knowledge advantages and thus opportunities for active money managers. However,
most active money managers underperform. They engage in behaviors that are unlikely
to lead to success. Although markets are inefficient, most investors do not have the skill
to discover and pluck the alpha fruit. On the whole, they will be better off if they hew to
the not-quite-correct theory of market efficiency.

Idiosyncratic Risk
Risk is involved in every investment, indeed in every business. This risk can be systematic
or nonsystematic. The latter appears as an idiosyncratic characteristic of a particular
company or fund. Idiosyncratic risks emerge even in so-called risk-free investments.
Compare, for example, a government bond from Iceland to one from the U.S. One is
riskier than the other. Although investors can diversify to eliminate idiosyncratic risks,
it remains relevant. Some institutions, such as Enron or LTCM, were so large that their
idiosyncratic risk affected even the most-thoroughly diversified investors. Probability is
the metric that allows investors to compare idiosyncratic risks. By this measure, stock
funds are riskier than hedge funds.
The Business of Asymmetry
The hedge fund, or absolute-return, business is a growth business. It has been growing
since the year 2000. Investors seem to have accepted the notion that long-only investing
is risky and that hedge funds are, perhaps, less risky. Many of the best and brightest
investment professionals are setting up hedge funds. Yet, one does not hear about such
hedge fund managers moving in the other direction. The default of a major hedge fund
could cause serious risks throughout the financial system, as happened in 1998, but it
is quite improbable.

About the Author

Alexander M. Ineichen, CFA, CAIA, is managing director and senior investment
officer for the Alternative Investment Solutions team, a business within UBS Global
Asset Management.
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