The myths and misconceptions of hedge funds

By Damien Hatfield

The article ‘Hedge funds fail the asset class test’ in Money Management (24 May 2001) is a particularly timely discussion of a number of important issues surrounding the place of hedge funds in investors’ portfolios. We thank Rob Keavney for his interest in and research of the industry. We feel bound, however, to address a number of the specific issues raised in his article.

The article is timely because we are currently witnessing very strong growth in interest in hedge funds among both retail and wholesale investors. In 1999, the world's largest pension fund, the California Public Employees' Retirement System (CalPERS), announced that it would commit $US11 billion to hybrid investments including hedge funds. The hedge fund market around the world is now estimated to be more than half a trillion dollars in total assets.

In Australia, retail investors have led the charge, with over $1 billion invested in the Westpac Capital Guaranteed OM-IP 220 Limited hedge fund product series and $180 million committed to the most recent offering of this product. Have all these investors got it wrong or is the hedge fund industry still clouded by myth and misconception?

Myth 1: Hedge funds are diversified managed funds that use derivatives rather than physical holdings.

According to the Australia Financial Review Dictionary of Investment Terms, an asset class is a broadly defined category of financial assets such as domestic shares, overseas bonds and cash among others. Rob Keavney is correct in stating that while hedge funds are not financial assets they do invest in financial assets. His conclusion that they don't qualify as an asset class by themselves is also correct, however it is also true that, following this logic, any investment that uses a pooled fund approach should not be considered an asset class.

It is a fallacy that "hedge funds are diversified managed funds that use derivatives rather than physical holdings". In fact, a better definition is provided by William J Crerend in his book Institutional Investment in Hedge Funds: "hedge funds are private partnerships wherein the manager or general partner has a significant personal stake in the fund and is free to operate in a variety of markets and to utilise investments and strategies with variable long/short exposures and degrees of leverage"

Hedge funds do not constrain their investment activities to derivatives. Most hedge funds do, in fact, operate in physical markets and 72 per cent of funds use derivatives primarily for hedging purposes, according to Alexander M Ineichen, in his paper "In Search of Alpha" for UBS Warburg.

Myth 2: All hedge funds attempt to profit from short-term market movements.

It is true that some hedge funds attempt to profit from short-term market movements (as indeed do some traditional fund managers), however this is not always the case. A more accurate description is that most hedge funds attempt to generate returns from exploiting market anomalies such as mispricing between similar securities. This often involves taking long (ie bought) as well as short (ie sold) positions. Equity strategies comprise about 70 per cent of all hedge fund strategies by assets invested.

Myth 3: Dividends and interest are irrelevant to hedge fund managers.

Contrary to the assertion in Keavney's article, dividends and interest income are very relevant to hedge fund managers. Clearly dividends are important for equity long/ short strategies. In some cases, for example convertible bond arbitrage, the level of interest income paid on convertible securities is a key element in the return equation. In all cases where futures are bought, the interest earned on cash deposits is also important for return generation.

Myth 4: Long Term Capital Management nearly brought the financial system to its knees.

We agree that hedge funds should not all be viewed as defensive in nature and the collapse of Long of Term Capital Management is frequently cited as evidence of this. However, the notion that "Long Term Capital Management almost brought the entire world to its financial knees" is not correct. It is now widely believed that concerns about the effects of LTCM's failure on the financial system were exaggerated by the Federal Reserve, which led the rescue of the collapsed hedge fund. This is the view of Professor Kevin Dowd of Nottingham University, who in his study of the relationship between the Federal Reserve and LTCM contends that the effect of the intervention was to help the managers and shareholders "get a better deal for themselves than they otherwise would have obtained".

It has been reported that LTCM's total losses amounted to $US 4.4 billion. Of the $US 4.4 billion, about $US 1.9 billion related to the partners' personal assets. About one quarter related to funds of European banks. In most cases, the original investments had been repaid; that is, the losses were mainly against profits which had been made. To put things in context, the loss represented about twice the level of the loss estimated in the collapse of Australian insurer HIH; a big loss perhaps but hardly a threat to the stability of the global financial system.

Myth 5: Hedge funds are risky investments.

Not all hedge funds are aggressive in nature, and most do not make large bets on the direction of one market relative to another. Indeed many attempt to remove market risk from their portfolios entirely. In this sense, hedge funds can be viewed as having some defensive characteristics.

Although we are aware of the shortcomings of relying on index data, principally because individual hedge fund manager performance can deviate significantly from the index, it is interesting to note that accorinding to research by Hedge Fund Research Inc (HFRI), the HFRI Equity Market Neutral index displayed an annualised volatility of 3.4 per cent over the ten year period ending 31 March 2001. This is lower than the level of volatility displayed by a typical Australian fixed interest portfolio over the period. The HFRI Equity Hedge index implies a volatility of 9.4 per cent over the same period, compared to 14.2 per cent for the S&P 500 Composite index.

Of course volatility does not capture other risks associated with an investment in hedge funds, as with any other investment. We disagree that leverage per se is at the heart of these risks. Fixed interest arbitrage strategies, for example, can be low risk to investors despite the use of considerable levels of leverage. Rather, leverage magnifies other portfolio risks such as too high a concentration in a particular strategy or insufficient controls in the investment management function. It has been estimated that 72 per cent of hedge funds use leverage and only 20 per cent have leverage ratios greater than 2:1 assets to capital. So the majority of hedge funds that use leverage are about as leveraged as the typical margin lending account.

It is also important to consider that many hedge fund managers come from a risk management rather than investment management background and most hedge funds are managed so as to mitigate risk.

Fact: Hedge funds are not a substitute for a portfolio of traditional assets. However, due to their unique risk/ return characteristics, they do warrant an allocation in a diversified portfolio.

One thing is certain, hedge funds have characteristics which differ from those of other investments. Accordingly, hedge funds should not be viewed as a substitute for a portfolio of traditional assets. These unique characteristics, however, allow investors access to risk and return properties which are not available through traditional investment products.

Extensive studies suggest that hedge funds can complement a traditional portfolio and provide benefits in terms of reducing portfolio volatility and potentially increasing returns. These benefits arise from the less than perfect correlations between hedge fund returns and the returns earned on traditional assets.

Investors can reduce the risks associated with an investment in hedge funds by maintaining a well diversified exposure to a number of different managers and strategies. One way to achieve this is through a properly constructed and managed fund of funds. A number of well regarded Australian investment managers have begun to offer these types of investments to the market.

Damien Hatfield is the head of Absolute Return Funds at Colonial First State Investment Managers.