Hedge funds in practice

This article looks at some of the issues of categorising hedge funds and deciding where the different types fit in building a sound portfolio. We also look at some of the key issues inhibiting investors and advisers allocating to hedge funds.

Firstly, should we see hedge funds as a separate asset class?

From a theoretical point of view we believe the answer is no.

Hedge funds are a collection of investment strategies that typically invest in mainstream and/or alternative asset classes and often use derivatives and leverage. We believe hedge funds are an ‘investment strategy’ rather than an asset class.

In practice in portfolio construction, however, it still makes sense to think about much of the hedge fund universe as an asset class.

Specifically, this covers non directional/market neutral hedge funds and collections of broadly diversified hedge funds — often invested in via a fund of hedge funds.

We still have to think about how much to allocate to them and any other alternatives, versus more mainstream assets, and have some sense how this will impact the overall portfolio risk and return characteristics.

We believe that an allocation of 10-20 per cent of a portfolio in these broadly diversified/market neutral types of hedge funds can make sense.

This is particularly the case as a key defensive component of a portfolio given the current low bond rates and an inverse yield curve — a generally negative environment for more traditional fixed income investments.

Some modestly geared versions of the same type of investments or exposure to such funds may also make sense for more aggressive portfolios.

On the other hand, when we are talking about specific ‘long biased’ hedge funds in the various asset categories, there is no need to include these in a separate asset class.

A more practical solution is to include them alongside long-only funds in the same asset class, for example long/short equity in the more general equity allocation of a portfolio.

Having said this, we do see strategy-specific hedge funds as a way of taking some market risk out of the particular asset class (whether it be equities, fixed interest/credit, or property securities) with potential gains and opportunities on the short side.

It is also about being able to access some of the most talented fund managers that are increasingly managing hedge-fund-like or benchmark unaware structures.

Including both diversified/non directional/market neutral hedge funds (the more defensive type) and long/short hedge funds (the more opportunistic type), it would not be unreasonable to have a total allocation of 25-35 per cent of a portfolio in hedge funds overall.

The question then remains how should investors access this sort of allocation? Directly, via fund of funds, or perhaps via multi strategy funds offered by one manager but covering a range of hedge fund strategies.

The key with direct hedge funds (unlike fund of funds) is that you have to understand in detail the strategy being undertaken by the manager and their capability to implement it. This can be straightforward in many long-biased equity or long/short funds that can be assessed much like traditional equity funds (albeit with some significant differences especially regarding ability on the short-side).

In other asset areas, for example credit, assessing the strategy and particularly manager skill is more difficult.

The recent case of the listed hedge funds Goldlink and Growth Plus is an example where we believe many direct investors and advisers had little understanding of the strategy and the risks involved.

Both funds have fallen in value by more than two-thirds in recent months, as the highly leveraged gold arbitrage strategy suffered in a challenging environment, and the risks have become more apparent.

The hedge fund universe offers a large array of interesting and potentially rewarding but often complex strategies.

If investors are going to access the more complex of these directly, they clearly need to know exactly what strategy they are getting into and the true risks involved rather than simply looking backwards at past returns.

Investing in a multi-strategy hedge fund run by one manager is a step down the diversification path but without the additional fees that come with a fund of hedge fund.

On the surface it seems a great solution. Investors get access to a range of hedge fund strategies through one manager, a more efficient fee structure, and benefit from the ability of the manager to allocate across various sub-strategies, often more quickly than a fund of fund is able to.

Moreover, as the hedge fund industry has evolved and some firms become institutionally-sized, perception is that the ‘blow up risk’ of these firms is reduced.

However, it is worth noting that Amaranth, a hedge fund manager that recently lost US$6 billion of investor capital (more than the infamous Long Term Capital Management debacle), was a multi-strategy fund.

Clearly, there is still the possibility that some multi-strategy hedge funds can concentrate too much risk in one single area, whereas fund of hedge funds tend to typically diversify these exposures.

However, as these firms become larger some problems also emerge. Are they more interested in asset gathering then investment performance? Can they still retain and motivate the best employees? (After all, many want to work for a hedge fund in the first place because they like working in a smaller group not a large organisation). Can they allocate across their internal hedge funds in a way that is value adding and free of conflicts?

When these issues are considered along with the amount of due diligence required in assessing the range of investment strategies used by a multi-strategy fund, they may not be the solution they first seem.

In the same way one validly asks whether a single manager can run all asset classes well for a conventional diversified portfolio, one can ask whether one hedge fund manager can run all hedge fund strategies well.

Fund of hedge funds are therefore the simple solution, although they clearly come with an additional fee load. The key is whether they justify those additional fees.

In our view, the key is having investment professionals who truly understand the full universe of hedge funds and the actual strategies they are assessing.

Among senior investment personnel assessing underlying hedge funds, you ideally need the sort of people who could actually run the hedge funds themselves.

Further, you want an investment team that is prepared to tilt the portfolio intelligently towards attractive strategies over time, rather than simply buying ‘the market’ of hedge fund strategies available.

Unlike multi-strategy funds, fund of funds do not face a conflict in leaving funds invested with an underlying manager, even if they do not like the strategy at all.

There is no doubt that hedge fund fees (and not just at the fund of fund level) are a big hurdle with many investors and advisers, and to some extent this concern is valid.

The idea of untested, start-up managers with no hedge fund experience taking 2 per cent base and 20 per cent performance fees (with no hurdle rate for the performance fee in many cases) is almost offensive.

Talented hedge fund managers should be able to get wealthy over the same investment time horizon that their investors are usually taking (that is, generally seven to 10 years and beyond).

We believe it is valid to criticise a system that allows some start-up managers to raise a lot of money quickly, punt on some risky positions and walk away with tens of millions in a couple of years or with little to lose if the fund blows up.

Fortunately, it is becoming harder for new hedge funds to get away with this, with the market becoming more mature and discerning, and in many cases with better fund of hedge fund managers able to negotiate lower fees across both new and existing managers.

Of course, some of the better managers can easily get away with ‘two and 20’ or more, and will simply refuse to negotiate fees. If the manager has the sort of investment edge that can still deliver attractive risk-adjusted returns on a consistent basis after this sort of fee impost, then there is no reason investors should not be prepared to pay it.

Having a simplistic rule that you will not pay above a certain fee level no matter what the strategy or return prospects are, is simply naïve in today’s dynamic investment environment.

Just because Macquarie Bank has a high cost structure with large salaries does not mean investors should exclude it from share portfolios, or that investors should refuse to invest in funds that hold it.

In a similar way, fees should not be a simply defined barrier restricting access to the best hedge fund managers.

Another recent response to the fee issue is hedge fund replication strategies.

Historically, passive hedge fund investment has comprised of a range of investable hedge fund index products, more akin to fund of hedge funds.

The performance of these index products has generally been disappointing compared to their non-investable index counterparts, as many of the best hedge fund managers either do not report their performance to indices or are closed to investment if there is no established relationship — in fact, the ability to access closed managers is claimed as an ‘edge’ by many fund of hedge funds.

Although it is a new and developing area, we have some major reservations in relation to the newer generation of hedge fund replication strategies that, in a different approach to hedge fund indices, attempt to mimic some of the core hedge fund strategies and associated return and risk factors themselves generally through factor models, mechanical trading rules or generating ‘hedge fund like’ returns with predefined return, risk and correlation objectives. Yes, they can get you exposure to some of the broad factors that have generated some of hedge fund returns historically. But often these are the very factors that you are usually looking to avoid in a well-run fund of hedge fund, or at least get exposure to tactically only when the opportunities look attractive.

Many hedge funds dynamically trade in and out of asset classes and most hedge funds do not operate in different markets than traditional investors, they simply use more dynamic strategies.

Factor models used by some replication strategies have issues in capturing this as they are modelled using data looking backward for several years and the portfolios are only rebalanced once a month.

Mechanical rules are prone to suffer from overcrowding as the rules they use imitate the most basic of hedge fund strategies, which are the most widely known and therefore also the most widely used.

The approach of generating returns with predefined properties is fairly opaque and the processes appear to have been developed primarily as an adjunct to risk management modelling.

Overall, replication is a very backward-looking approach to hedge fund investing, and while such approaches are dangerous in almost all forms of investing, they are probably most dangerous in hedge funds.

In conclusion, hedge funds are here to stay although the line between conventional and hedge fund managers will continue to blur. Some of their criticisms are valid.

But investors should not avoid hedge funds for simplistic reasons. In a world of expensive asset classes they have a valuable role in diversifying portfolios that is only likely to be highlighted in a more difficult investment climate.

It is not as if conventional asset classes and investment strategies do not have their flaws either. It will just take a bear market to make them visible to more people.

Dominic McCormick is the chief investment officer and Robert Graham-Smith is portfolio manager, alternatives at Select Asset Management .