Hedge funds fail the asset class test

As the push into defensive assets continues while markets head south, neglected asset classes continue to attract more of the spotlight. However Rob Keavney argues not all are what they seem and should be regarded in a different light.

I recently had two things explained to me: hedge funds are an alternative asset class and they are a defensive asset class. I don't believe either of these positions.

Hedge funds invest in asset classes, but they are not one themselves (unless perhaps there is a new tax-driven agricultural scheme which grows garden hedges). Hedge funds invest in shares or bonds, currencies, commodities, etc, although they do not do this by obtaining physical holdings but rather by derivatives (futures, options, etc).

Some hedge funds specialise in only one of these markets, but most diversify. Thus, most hedge funds are diversified managed funds that use derivatives rather than physical holdings. This creates very different investment characteristics from conventional managed funds.

First, it is theoretically possible for hedge funds to profit from falling markets as well as rising ones. This is the factor that is encouraging the myth that they are defensive.

Second, physical holdings can be very long-term where as derivatives are essentially short-term in nature. Thus, where a conventional managed fund can represent a long-term strategy of investing in the returns produced by an asset class, hedge funds rely on the short-term trading skills of the manager.

Many financial planners pay lip service to the principle that "no-one can time markets". You can either hold this view or recommend hedge funds, but not both. The only way hedge funds make money is through correctly anticipating short-term market movements.

There are other views frequently expressed by planners which are not appropriate to hedge funds such as 'it's time in, not timing, the market'. Apart from scepticism about market timing, this comment reflects a belief that the essence of investing is to maintain holdings in assets which will inevitably deliver long-term profits. No hedge fund manager attempts to do this.

Third, derivatives do not produce regular or predictable dividends like property, shares, bonds or cash. Making trading gains or losses is the entire game.

In conventional investing, the regular receipt of dividend/rent/interest can allow investors to be less concerned about capital declines, as cost of living can be sustained from income while waiting for recovery in capital value. This does not apply with derivatives.

These factors need not totally exclude hedge funds as an investment option but, if planners are moving away from principles that they have previously relied on in portfolio construction, it is important that they recognise that they are doing so, and have a clear objective in mind.

This brings us to the suggestion that hedge funds can be defensive.

It is a useful context to recognise that futures contracts can be extremely high-risk assets. Long Term Capital Management almost brought the entire world to its financial knees. The essence of the problem was the degree of gearing inherent in most futures contracts. It is a truism that gearing increases risk, so massive leverage, as is possible using derivatives, massively increases risk.

However, not all hedge funds take such large-scale, open-ended risks. Many pursue strategies designed to limit upside and downside. This reduces their risk but it does not mean they are low-risk, in the way that a bank bill is. You cannot fail to make a profit in a bank bill.

Hedge funds can be market neutral, which is one of the reasons they are presented as being defensive. They can be structured to eliminate general market movement and, say, bet that a particular stock will under or outperform the market average, whether this is rising or falling.

It's also possible to take a position which will profit if either a market, or a particular security, declines. In these situations derivatives are very different from conventional investments. They can profit in falling markets or from falling securities.

However, this does not guarantee they will make better returns in falling markets than traditional investments. There are four possible outcomes. They can:

- Profit when markets fall or rise;

- Lose when markets fall or rise.

The latter two are as important as the former. It is possible for them to profit when the markets rise or fall, but equally they can lose under both conditions. This makes them likely to be not highly correlated with conventional investments, which can aid portfolio diversification, but it does not mean they'll necessarily perform well in a declining market.

Hedge funds are being embraced as defensive in the expectation that markets, or at least equity markets, may be in a bear phase. Although I am not arguing that hedge funds can have no place in a portfolio, there are alternative and less exotic strategies that can cope with bear markets.

There is an investment which is guaranteed to make a profit in a declining stock market. It is called cash. There are other investments which can be more profitable than cash, which are also not dependent upon stock market movements. They are called bonds.

Of course, I am showing my age in even suggesting such out-of-fashion and untrendy strategies. They certainly are not macho.

Despite this character failing, if the rationale for adopting exotica is concern over market weakness, I believe it is worthwhile exploring the relative merits of less exotic defensive strategies.

Normally, if we think of an asset as being conservative or low risk we would mean it is unlikely to experience a loss, or is highly likely to pay regular income. This is certainly true of cash. It is not true about hedge funds.

However, it may be argued that hedge funds will outperform cash. Indeed, promoters of these investments sometimes suggest they can make 10 per cent plus per annum, year in and year out, irrespective of market direction.

As we are in a low-inflation environment, say two to three per cent per annum, this is a promise of a seven to eight per cent real return without downside. If you believe this then buy all you can, and also have faith in the tooth fairy.

The Australian stock market over the 20th century produced a real return of about eight per cent per annum, but it came with considerable volatility. If someone has invented an investment that performs as well as the highest return asset class, but with the risk of a low volatility asset class, then forget diversification, forget equities and invest everything in these 'can't lose' investments.

However, if we are to be realistic in assessing the prospect of investing in hedge funds, consider the following. Would you recommend a fund which was managed by an organisation you are unfamiliar with and which described its offering as follows:

* We invest in assets with very low transaction costs;

* In return we have forsaken all income yield from the portfolio;

* We run a diversified fund which invests across a range of assets;

* There will be no attempt at a long-term investment strategy, rather we will trade extremely actively on an hourly, daily, or at most weekly basis;

* The return of the investment will depend almost exclusively on the capacity of a small team of individuals to consistently time markets correctly;

* We may gear the fund to a very high degree, far more than the Colonial First State Geared Share Fund, or any growth property trust, and more than any margin lender would support;

* We may apply the word "defensive" but this does not mean you can't lose money, any more than the term "capital stable" precluded falling values in 1994;

* We will take a higher than average management fee, including a success fee which, if the fund is profitable, would produce a MER which far exceeds any other product you have ever recommended;

* Rather than call it a diversified managed fund we will call it a hedge fund; and

* We could produce very significant gains or losses but, if we do well, the returns could be outstanding.

I would suggest that this is a fairly realistic analogy for the offering of many hedge funds but do acknowledge that there is a very broad range of vehicles included under this term.

Such a fund would, conventionally and reasonably, be described as following an aggressive, not defensive, strategy. Some such funds do have impressive track records over a number of years.

It is worth noting that the last decade has (barring international stock markets over the last 12 months) seen strongly rising values in all asset classes. Thus, while it is true that derivatives don't need rising markets to be profitable, it's equally so that the only markets in which hedge fund operators have had the opportunity to establish a long-term track record have been rising ones. Geared exposure to almost any market would have been profitable through most of the 1990's.

These funds have not had the opportunity to actually demonstrate their abilities in consistently falling markets in recent years. The fact that fund managers with whom we are familiar are packaging and marketing multi-manager hedge funds does not change the underlying nature of the investment and therefore should not, in itself, give us any sense of comfort.

Planners need to understand clearly the nature of these new investment options and recommend them only to the extent that their unique risk/return characteristics fit within a client's overall strategy.

This need not preclude them but it is far from entitling them to a position as a fourth fundamental asset class, along with shares, property and interest bearing securities.