Hedge fund debate ignites

Rob Keavney is no stranger to controversy. A recent article Keavney wrote to counter some of the extremes of exuberance on hedge funds sparked a number of detailed responses from industry players. The following two stories encapsulate the main points raised by these commentators. The two stories are followed by Keavney’s response.

By Dominic McCormick

In an industry that seems increasingly obsessed with the value of its own businesses rather than clients investments, Rob Keavney regularly makes sound contributions to debate on investment issues.

Unfortunately, his latest effort (Hedge funds fail the asset class test - Money Management May 24, 2001) conveys little understanding of hedge funds and risks giving planners an excuse to maintain ignorance, to the ultimate detriment of clients.

Rob firstly states that hedge funds cannot be seen as an alternative asset class because they themselves invest in other asset classes. Secondly, he asserts that hedge funds do this via derivatives rather than physical holdings. Thus, he concludes, "most hedge funds are diversified managed funds that use derivatives rather than physical holdings".

Asset classes are defined primarily by a degree of positive correlation between their component parts (securities) and by their lack of correlation with other groups of securities or investment types. It is obvious that many hedge fund strategies (eg. market neutral equity, convertible arbitrage) show little correlation with mainstream asset classes nor to the actual assets that are used within these strategies.

It is true that some strategies such as long/ short equity tend to be somewhat correlated with equity markets and so could easily be included in the equities asset class. However, the majority of market neutral and arbitrage related hedge funds have little in common with the assets in which they are invested from a risk/ return perspective and could easily be seen as an alternative asset class. In any case the real debate is whether they have a role in client portfolios, not how they are classified for asset allocation purposes.

On the second point Rob is simply wrong. Many hedge funds do not use derivatives at all or use then sparingly while few hedge funds strategies do not use physical holdings. According to a recent report by UBS Warburg, 28.1 per cent of hedge funds did not use derivatives at all. Another 48.8 per cent used derivatives for "hedging only"

Rob then compounds his error by arguing that because derivatives are essentially short-term in nature compared to physical holdings that can be very long-term: "hedge funds rely on the short-term trading skills of the manager".

It is true that hedge funds are more dependent on the skills of the manager then traditional funds, which rely heavily on the underlying trend of asset classes. However, this, I would have thought, is exactly the point. By being more dependent on these skills, hedge funds are less reliant (and diversify away from) market risk.

However, the skills employed by many hedge funds go well beyond short-term trading. In many cases they cover all of the skills employed by traditional managers plus more. For example, successful risk arbitrage involves significant knowledge and skills in the areas of corporate law, tax and even politics in addition to trading and investment skills.

A minority of hedge funds strategies such as managed futures and macro funds do emphasise short-term trading skills. Such funds tend to have very low or negative correlation to traditional asset classes and can therefore make a valuable contribution to portfolio diversification. These types of funds make up less than one third of total hedge fund strategies.

A number of hedge fund strategies are long-term focused (eg distressed debt) and most are focused at exploiting inefficiencies in markets (both short and long term). Rob's statement that "the only way hedge funds make money is through correctly anticipating short-term market movements" is therefore incorrect as is his comment that "No hedge fund manager attempts to...maintain holdings in assets that will inevitably deliver long-term profits".

Making reference to the "no-one can time markets" argument, Rob states that you can "either hold this view or recommend hedge funds but not both". Rubbish! Timing, in the broad sense, is part of any active investment strategy, traditional and hedge funds. The stockpicker who bought Cisco five years ago is a hero while those who bought the same company in March 2000 is perceived as a loser. Either you believe in active management and therefore embrace an element of timing, or you take a passive/index approach. Only to a true believer in "efficient markets" would hedge funds not make some sense.

I suspect Rob believes in active management. For example, "timing markets" is the main activity of Valu-trac's World Wide Strategy Fund, a fund both Rob and I have strongly supported in the past. In any case, Rob's argument is wrong for the majority of hedge fund strategies that do not rely on short-term market timing for success.

Rob then discusses the "myth" that hedge funds are defensive. Obsessed with the flawed view that all hedge funds focus on "short term trading of derivatives", he lectures on the risks of futures contracts pointing out the extreme leverage of Long Term Capital Management prior to its collapse. Yes, it is true that excessively leveraged hedge funds in extreme market conditions will occasionally "blow up". However, this does not mean the whole spectrum of hedge funds should be naively tainted with the same brush.

Leverage is an issue for hedge funds but it should not be overstated. According to the UBS report, 72 per cent of hedge funds use leverage but less than 20 per cent are leveraged more than 2 to 1 (i.e. the ratio of total to net assets). In the article, Rob implies that hedge funds are geared "far more than the CFS Geared Share Fund". Wrong again! Most long/ short equity hedge funds (the closest in structure to normal equity funds) are leveraged less than two times. The CFS Geared Share Fund has actually been leveraged more than 2 times for much of its life, as are many margin lending clients.

No one argues that hedge funds cannot lose money. No one argues that they are guaranteed to make money in a bear market. Different hedge funds carry different levels of risk but in terms of volatility and chance of capital loss, most market neutral and arbitrage hedge funds, and fund of funds focusing on these areas, have proven themselves to be, and can comfortably be described, as defensive. The nature of the investment strategies they employ is such that they do have greater ability to deliver returns in difficult markets. Rob seems to agree that bonds are defensive but we all know bonds can also lose money over the short-term.

Apart from leverage, there are many real risks and issues that should be understood by financial planners recommending hedge funds. These include key person risks, transparency, capacity constraints, illiquidity, relevant benchmarks and the quality of historical data. Unfortunately, none of these issues are addressed in Rob's article.

Rob then questions the likely future performance of hedge funds. How about looking at the facts? Most hedge fund strategies (and fund of funds) have indeed produced returns of 10 per cent or better and have produced returns better than Australian shares with lower volatility. Of course this is history but it could be argued that returns from many hedge funds are more reliable than those from other asset classes exactly because so much of the return comes from the skill of managers in exploiting inefficiencies compared to traditional funds that are dependent on bull and bear trends in markets.

Rob then lists 10 characteristics of a hypothetical hedge fund full of the misconceptions his article has constructed. This "fund" is unlike any hedge fund I have seen and differs dramatically from the "fund of fund" hedge funds being made available to investors in Australia.

In the final paragraphs, Rob contradicts himself. Having stressed earlier that hedge funds were about "short-term trading of derivatives", he now discounts their recent performance by saying "geared exposure to almost any market would have been profitable through most of the 1990s". Rob, you cannot have it both ways! Either you believe hedge funds are about short term trading in which they don't benefit from long- term market trends or they involve a longer-term element and therefore benefit from these longer-term market trends.

Perhaps Rob should actually meet a few hedge fund managers. He may find that many of them are diligent and intelligent professionals and not the short-term punters he portrays. The fee structure of hedge funds attracts some of the best talent in the funds management and investment banking industries. Many traditional fund managers are not flexible enough, smart enough or simply not allowed to adopt many of the strategies that hedge funds implement. Furthermore, because hedge fund managers specialise in what they do (and invest their own money in the fund) they tend to become pretty good at what they do.

I am not saying that all hedge funds are sound or that planners should automatically include them in client portfolios. Planners need to examine the characteristics of any individual hedge fund closely and, in the case of fund of funds, develop confidence in the people selecting managers and strategies.

Unfortunately, in assessing hedge funds, financial planners have been forced to rely primarily on one-off reports by the research houses. These are typically paid for by the fund manager, often are written by more junior analysts and usually do not even provide a specific recommendation. A greater focus on this area from research houses is clearly required.

Rob concludes by saying that "Planners need to clearly understand the nature of these new investment options and recommend them only to the extent that their unique risk/ return characteristics fit within a clients overall strategy". This is probably the most sensible point in the entire article.

That Rob Keavney, a well regarded industry commentator and head of a long standing financial planning firm, has such a poor understanding of hedge funds only makes one wonder how poor the knowledge of the vast majority of financial planners (and investors) must be. Much more education and industry discussion on the issues is obviously required.