Rethinking hedge funds following the GFC

Having sustained enormous criticism following the GFC, hedge funds are still struggling to garner favour among investors. Richard Keary explains why the sector did not fail.

The hedge fund investment model is not broken, and it did not fail in the market turmoil of 2007 and 2008. Yet many investors have exposure to products that might leave them with the distinct impression that their hedge fund investments did fail.

There are two issues that need to be considered. One is the investment model, and the other is the product model. In other words, how did the underlying investments perform through the global financial crisis (GFC), and how was this affected by the way the investments were delivered?

The performance of the investment model can be assessed by looking at the broad aggregates that are provided by different firms. In this case I have chosen the Dow Jones Credit Suisse Hedge Fund Indexes. This is not about individual managers, it is about the investment model – so looking at aggregate level data is appropriate.

If we can conclude that the investment model did not fail, then a conviction to never invest in hedge funds again should be replaced by a determination to set higher product design standards next time.

Assessing the investment model

Figure 1 shows the performance of the Dow Jones Credit Suisse Hedge Fund Index (Hedge Fund Index) relative to the S&P 500 Total Return and the All Ordinaries Accumulation Index (AOI). The Hedge Fund Index and the S&P 500 are in USD while the AOI is in AUD.

Figure 2 shows the same data for the period starting December 2006 to capture the GFC and recovery.

Notwithstanding the resilience of the Australian share market, the Dow Jones World Index Hedge Fund Index has produced similar return at observably lower volatility in both cases.

One can also observe that the losses in 2008 were smaller for hedge funds and the recovery faster. Neither the S&P500 nor the AOI have recovered their 2007 peaks.

Given that equity markets are the main driver of risk and return in securities portfolios for most Australians, it is worthwhile looking at the performance of equity hedge funds compared to the equity indices.

Figures 3 and 4 show the cumulative performance of the S&P 500 Total Return Index and the Equity Long/Short hedge fund index.

Given the high correlation between equity markets, the S&P500 TR can be used a proxy for equities in general.

Over both time frames it is hard to argue that the S&P500 TR is a better investment than Equity Long/Short hedge funds, which have delivered better return at much lower volatility.

Managed futures is a hedge fund strategy that is probably the standout for its success over the past three years – including the depths of the GFC.

Managed futures managers (also called commodity trading advisers) follow a systematic approach to investing that is a pure distillation of the momentum factor. That is, they look for trends and are indifferent to whether those trends are up or down.

In 2008 when the trend in most asset prices was down, Commodity Trading Advisors (CTAs) generally identified that trend and positioned themselves accordingly.

As a result, CTAs as a group posted positive returns. This is not a failed investment model; if anything, it is a validation of why investors need to incorporate hedge funds into their investment universe.

Product failures

So if hedge funds did so well why are there many investors feeling rather let down by the whole experience?

I believe that the hedge fund product model was the source of problems and therefore should be the focus of learning. But firstly, what do I mean by the product model?

The way the investment is delivered is referred to as the product model. Product failure can mean many things but one example is when the product itself causes an otherwise temporary loss to become permanent.

If we investigate this line of thought we come to the intersection if leverage and liquidity.

Asset liability mismatch

The Australian market and its platform processing paradigm demands frequent transactions (product liquidity).

Product vendors took a punt that they could offer product liquidity that was better than the liquidity in the underlying investment.

They relied on using cash inflows to satisfy the liquidity requirements of a small number of investors.

When things were good this system worked well.

When investors panicked and redemption orders piled up, the redemption orders could not be satisfied from inflows – and the underlying asset was not liquid enough to sell in an orderly fashion.

As soon as investors realise this they know they have to be at the head of the queue, so a flood of redemption orders come in and it becomes impossible to satisfy investors.

This results in one of two outcomes: the fund is frozen until the underlying assets are liquid enough, or the fund is liquidated.

There is nothing in this scenario that says the underlying investment was bad. Yet the investor would have the distinct impression that something had really gone wrong – and it did, in the product structure.

Using leverage to increase assets under management

One must applaud the business merit of this strategy. Take $100 of assets and turn them into $200 of assets by borrowing.

Charging fees on $200 of assets is a good deal for the manager (I am being facetious, if it was not obvious).

The problem is that the lender takes a charge over the equity capital in the structure provided by the investors.

If the underlying assets are falling in value and they are not liquid enough to be used to deleverage the structure, then the lender can refuse to return the equity to investors until all the assets are sold and the loan repaid. In the case of some of the assets that can take years.

There is nothing in this scenario that says the underlying investment was bad. This is leverage at work.

Having pointed out some product flaws, I would like to return to a more optimistic note and identify what investors should look for in a product.

• Simplicity – The value proposition of a fund has to make sense and one needs to be able to see how that value proposition flows through to the investor.
• Liquidity – Liquidity at the fund level (ie, the liquidity offered to you the investor) and the liquidity of the underlying investment should be consistent. Investors should accept that not all investments can be delivered on a daily basis.
• Transparency – The ability to ask for detail about the underlying investments is an important monitoring tool to manage the potential agency risks of using fund managers. This does not mean you need to see holdings every day, it does mean that you need to ask the manager if they will show you holdings (even on a delayed basis) if you asked to see them (ie, you are testing if the product provider themselves has negotiated the right level of transparency).
• Value for money – Understand how much of the performance is being taken away in fees.

I firmly believe the hedge fund investment model is intact.

However, over the past decade of being involved in the hedge fund industry in Australia, I have said many times that just because it is called a hedge fund does not mean it is hedged.

There is no doubt people have made investments in so-called hedge funds where the investments did not perform as expected. This is not the same as saying that the hedge fund investment model is broken.

Why is this important now?

Are you asking yourself, ‘why would I bother?’ We don’t often witness secular changes in investment markets.

Secular trends are by definition long and therefore turning points are infrequent. There is little consensus about the path of inflation or deflation from here over the coming five or more years.

There are cogent arguments that support an inflationary world. After all, inflation is and always is a monetary phenomenon.

With the amount of money that has been created, inflation must be certain. Or is it? The Federal Reserve, through its quantitative easing programs, seems to be more concerned about fighting deflation.

Either way, neither deflation nor inflation is good for equities. Look at Japan since 1990 for the deflationary experience.

The 1960-1980 period in the US shows the ravages of inflation on equity market multiples.

As expectations for higher inflation and higher interest rates become impounded in people’s beliefs, the multiple they will pay for future earnings falls.

Even if earnings rise in a nominal sense the multiple is crushed and a broad index can be trapped in a sideways range for years.

There are some business models that will be able to weather a higher cost of capital. There are business models that won’t.

Good investors will be able to distinguish between winners and losers, whereas the benchmark index by definition contains all the winners and losers.

The arithmetic of a static allocation to equity market beta may not make sense if indeed we are facing either an inflationary or deflationary future. This is a good time to think about hedge funds but it is not the time to ignore the product lessons learned over the last few years.

Richard Keary is the CEO of FRM Australia Pty Ltd.