It’s not all bad news

Dominic McCormick

Hedge funds and fund of hedge funds continue to get mixed coverage in the financial media and investment industry generally.

Advisers and investors looking for an excuse to avoid hedge funds don’t have to go far to find such criticism.

The Australian PrudentialRegulation Authority (APRA) and Warren Buffet have provided fodder for the latest batch of condemnation.

But how much of this is soundly based analysis from a position of knowledge and how much is just regurgitated platitudes with limited understanding of the rapidly developing and complex hedge fund universe?

It raises the question whether some participants in the investment industry are making overly simplistic judgements on the pros and cons of hedge funds, and whether investors’ portfolios may suffer as a result.

Part of the problem is hedge funds, by nature, are a diverse range of strategies and managers and transparency, particularly when accessed through fund of funds, is limited.

Adding to this is fund of fund product structures have become more diverse and complex.

In the same way high conviction equity portfolios have regained popularity, a new suite of more concentrated and regionally focused fund of hedge funds have emerged.

Some products have capital guarantees and varying levels of leverage. A number of listed hedge fund and fund of hedge fund products have also been launched. In some of these, product fees have been too high and performance of some of the more recent product innovations has been disappointing, at least to date.

However, these disappointments have also helped to provide ammunition for the opponents of hedge funds and some easy excuses for those advisers and investors seeking to avoid them.

However, all this is hiding the simple reality that lower risk hedge funds and well-managed, well-diversified fund of funds aiming for low correlation with equity markets (with modest or no leverage) can be an ideal addition to the defensive component of investors’ portfolios.

Indeed, this is at a time when the true defensive options available for investors are greatly limited.

High quality bonds may still have some diversification benefits for a (low probability) deflation scenario, but the best return investors should expect in more normal scenarios is their current yields, which, after costs from a standard fixed interest fund, is probably below cash at around 4 per cent to 5 per cent per annum. In an inflationary scenario, bond rates would almost certainly rise and returns could easily be negative.

Investors have therefore gone up the credit (and leverage) curve in the search for higher returns from their fixed interest allocations.

However, the prospective marginal return from taking on more credit risk is lower than it has been for many years, and credit events such as the collapse of Westpoint in Australia and the continuing problems in the US sub-prime mortgage market are a stark reminder that there is no free lunch from taking on such risks.

Listed property and even infrastructure have experienced structural and valuation changes in recent years, which arguably push them out of the ‘defensive’ category.

One strategist recently called global property the most overvalued asset class around, and the risk profile of local property trusts has increased significantly as gearing has escalated and the more volatile profits from development and funds management become a larger proportion of total earnings.

These assets may well have a role in a diversified portfolio, but over-emphasising their defensive characteristics is likely to lead to disappointment.

Of course, some advisers and investors don’t believe they need a defensive component in their portfolios at all. Australian equities have returned around 20 per cent per annum for the past few years with seemingly little risk: why not expect this (or even half of this) going forward?

The key problem is those equities are now priced at valuations that suggest significantly lower returns in the medium to longer term (although this doesn’t tell us much about the near term).

The main concern for investors and advisers should not be a share market ‘correction’ or even bouts of higher volatility such as occurred recently.

All other things being equal, such periods can simply create good buying opportunities. The big concern is an extended period (that is, years) where equities produce poor or even negative returns. I believe only a very small proportion of clients of financial planners are able to ride through such periods with a fully invested (let alone geared) equity portfolio.

For most clients, it therefore makes sense to consider lower risk hedge funds and fund of hedge funds, as they are one of the few defensive investments available that offer the prospect of attractive absolute returns relative to cash in a range of environments.

Perhaps some parts of the hedge fund industry have created excessive expectations of returns from hedge funds, but we are not talking about shooting for the moon here. Conservative hedge funds and fund of hedge funds are about preserving capital and providing 2-4 per cent per annum above cash and bonds with low volatility. These returns have been achieved and are achievable going forward by the better managers in the space.

Some still refuse to go near hedge funds because they perceive them as too risky. I am continually amazed that there is still a widespread perception that all hedge funds, and even un-levered, diversified fund of hedge funds, are high-risk investments.

In overseeing multi-manager portfolios across the full range of asset classes and investment strategies, my experience is that the un-levered, diversified fund of hedge fund exposure is the component that causes me the least concern on an ongoing basis from a risk perspective.

Conventional bond funds, on the other hand, worry me considerably. Of course, hedge funds are far from risk free; they introduce a range of other risks into the equation, but this is the point, incorporating an exposure with a range of risks rather than one big risk (such as equity market risk), otherwise known as diversification, is central to portfolio management for risk averse investors. Those who avoid hedge funds because they don’t understand them and simply take a view that they are too risky are doing themselves and their clients’ portfolios a considerable disservice.

However, it is not surprising that advisers and investors are getting this message.

APRA, for example, recently reiterated its 2003 concerns about alternative investments, and hedge funds in particular, providing a list of key questions that should be considered by superannuation trustees covering regulation, risk management systems, service providers, correlation of underlying investments, transparency, lock ups and fees and so on.

These are all totally valid questions and concerns, but they apply equally to all conventional investments as well.

More importantly perhaps, APRA seems to imply that the only reason investors are adding alternative assets are for an aggressive grab for higher returns by taking on higher risks. In fact, the primary reason many progressive investors target exposure to alternatives and hedge funds in particular is to decrease risk.

Having said this, there clearly are some valid concerns relating to hedge funds.

Some fees are too high or poorly structure and there are plenty of poor and mediocre managers in the hedge fund universe (this is why a fund of hedge funds can make sense).

Does it make sense that every start up hedge fund, no matter what the strategy, feels they are entitled to an industry ‘standard’ 2 per cent base and 20 per cent performance fee with no hurdle? Of course not.

Still, better managers can justify high fees and funds are ultimately judged on risk-adjusted performance after all fees.

Increasingly, some better known fund of hedge funds are in a strong position to negotiate fee rebates and better terms from underlying managers.

Of course, most hedge funds also face some structural constraints that don’t apply to mainstream investments. These include less frequent pricing and liquidity. While these are practical considerations for platforms and advisers, they should not be overstated for what are supposed to be long-term client portfolios.

Investors and advisers have increasingly been inundated with new ‘structured’ products around hedge funds.

Many of these are primarily about making money for the fund managers and distributors rather than investors and are a long way from the more sensible hedge fund investment offerings I am referring to.

Some have leverage as much as four and five times, so you can say goodbye to capital preservation as a key objective. Others have expensive guarantees that almost certainly help push returns down towards and perhaps below cash.

Some listed hedge fund vehicles have been launched with little thought about discount control mechanisms to ensure investors actually receive the returns from the underlying hedge funds.

Such products are recipes for disappointment, but ironically, it is these products that seem to escape the more general criticisms of the hedge fund industry and more traditional hedge fund products.

Those looking for excuses to avoid hedge funds will therefore have no problems in finding them.

Indeed, the industry and media will regularly throw the spotlight on minor and major hedge fund ‘blow-ups’ that give the critics another chance to gloat about how smart they were avoiding a hedge fund investment at all. They shouldn’t. In fact, the best returns for hedge funds as a group tend to come immediately following such high profile failures and ‘crisis’ periods.

Look back to the aftermath of the LTCM debacle in 1998, or even the more recent collapse of Amaranth in September 2006.

The months and quarters following these events tend to bring about some of the best periods of performance for hedge funds generally. When hedge fund failures hit the headlines, it is normally a good time to be adding exposure.

Whenever there is a dislocation in markets, hedge funds are often either blamed for the crisis or seen as its major casualties. Rarely is the first premise true, and while the second is sometimes the case at an individual fund level, it is rarely very damaging to broadly based fund of hedge funds.

For example, even those funds of hedge funds that had allocations to Amaranth quickly recovered.

As another example, in contrast to the perceived wisdom, a number of fund of hedge funds are actually benefiting significantly from the US sub prime mortgage crisis through exposure to managers with short and hedged positions in the area.

Those, like Warren Buffet, waiting for the hedge fund industry to disappear in some kind of derivatives ‘blow up’, are almost certainly going to be continually disappointed.

Hedge funds are now a key part of the investment landscape, and this is likely to remain the case going forward. Variations on the current fund of hedge fund universe will continually evolve and there may be increased pressure on fees, but the basic rationale for diversification across a range of hedge fund strategies and managers will not change.

The desire of investors to have a component of their portfolios in strategies that produce absolute returns and that are lowly correlated with traditional assets will continue.

Jeremy Grantham of GMO suggests well-run, lower risk hedge funds are one of the very few safe havens in a world of overvalued investment markets.

Some smart advisers and investors realise this and have been comfortable with hedge funds for years. Other advisers are still making simplistic excuses as to why their clients are not invested there.

Recently, we have heard of planning groups that have decided to reduce or eliminate their holdings in hedge funds, perhaps for some of the reasons discussed above.

It raises the question as to where they are reallocating that money. Bonds at 5 per cent per annum, property securities at about the same yield and with greater risks described above, or more Australian and global shares? Perhaps some of the structured product gimmicks hitting the market? Perhaps they are just going partly to cash and waiting for opportunities to emerge in other classes (probably the only other truly ‘defensive’ move among these).

Will they be the same groups that are scrambling for low risk hedge funds and other genuine defensive options in the next extended equity market downturn (potentially when it is too late)? Time will tell.

Dominic McCormick is the chief investment officer at Select AssetManagement.