Learning the right lessons

The recent problems of several specialist high yield/hedge fund managers have dominated the media in recent weeks with the messages to investors and advisers confusing, to say the least, particularly in an environment where volatility across financial markets has increased significantly.

Clearly, there are some important lessons to come out of these events, but perhaps not the ones getting the attention.

More concerning, however, is the risk of knee-jerk and irrational responses to the situation that compound earlier mistakes and are detrimental to client portfolios.

So what are the right lessons?

Firstly, the media has taken the easy route of branding all the problem funds ‘hedge funds’ even though many of these were not.

The fund suffering the most damage, the Basis Yield Fund, was actually a specialist leveraged credit fund playing at the riskiest end of the debt spectrum — the first loss or equity tranche of collateralised debt obligations (CDO).

Some of these largely illiquid CDOs were exposed to the US sub-prime problems.

While the other affected Basis fund is clearly a hedge fund, the Absolute Capital and Macquarie Fortress products that have featured in the media are not hedge funds either.

As well as the considerable leverage inherent in the CDO structure, there was up to three times leverage at the Basis Yield Fund level. That one margin lender was reportedly also then willing to lend four times investors’ money (80 per cent loan to value ratio (LVR)) is mind boggling. I’ll get to leverage again later.

It seems some planners were using this high-risk credit fund as a significant part of a client’s fixed interest component. Clearly, many didn’t understand the complexities and risks of the product.

However, even without understanding all the intricacies, it was reasonably apparent the strategy entailed considerable and growing credit risk.

One only had to look at a graph of narrowing credit spreads in recent years to highlight that risks across all areas of credit were growing.

You did, however, also need the discipline not to be swayed by past performance and look forward not backwards. There are likely to be more ‘high yield’ funds that will have issues as the current credit bubble subsides, although in most cases they will not be terminal.

But rather than a question of how much and whether exposure to leveraged credit made sense, the lesson some are taking from the Basis situation is that one should never invest in, or recommend, anything one doe not understand, particularly hedge funds.

The problem is, taken to extremes, many investors and advisers would end up investing in very little.

How many people really understand what goes on inside a local insurance company such as QBE or a global conglomerate like GE?

And didn’t many Westpoint and Fincorp investors feel good because they were investing in loans backed by ‘easy to understand’ property?

In my view, the proper lesson in the case of both global shares and hedge funds/complex specialist fund products is employ a fund manager — a multi-manager or fund of hedge fund.

There is certainly no guarantee that these managers will avoid all problem funds (although the better ones should avoid most) but importantly when they do end up exposed to such a fund, the look-through portfolio exposure for clients holding the fund of hedge fund is likely to be minimal.

If an investor had 10 per cent in a well-diversified fund of hedge fund and that fund had a 3 per cent holding in a fund that lost 80 per cent of its value, the impact on the client is only 0.24 per cent. However, if a client had 10 per cent of their total portfolio in the same fund directly, their portfolio has taken a very damaging 8 per cent hit, particularly if this is the supposedly defensive component of the portfolio.

Clearly, the lesson is to be able to properly distinguish between the very different risks of individual specialist and hedge funds compared to multi-managers and fund of hedge funds. What you need to know as an investor or adviser also differs depending on which you are investing in.

If one is talking about direct investments into a hedge/specialist fund such as the Basis Yield Fund, then one has to understand the strategy and portfolio well enough to gain a strong sense of the risks and where it fits into a portfolio and whether the exposure should change over time.

However, if one is talking about investing in a fund of hedge funds or multi-manager fund, the more important issue is can the people running the fund of fund and making allocation/selection decisions understand the complexity and likely risks and returns of the underlying strategies and, further, do I trust them to use this ability well and with the interests of investors in mind?

Well-run fund of hedge funds and some multi-managers are clearly a better way to invest across the hedge/specialist fund spectrum for advisers and investors who cannot be expected to understand all the complex underlying strategies being used (but who want and need access to the returns and diversification benefits they can provide).

This is clearly very different from an individual hedge fund or specialist fund. It’s like the difference between an individual stock and a diversified equity fund.

Indeed, although clearly not immune to recent broader market volatility, well-diversified, unleveraged fund of hedge funds have held up well through this difficult period, although some more concentrated and highly leveraged fund of hedge funds have suffered. Listed funds that have both leverage and the additional component of market sentiment over and above actual net tangible assets (NTA) performance have been particularly volatile.

In fact, a number of individual hedge funds were actually able to make money out of the worsening sub-prime situation because they could go short and profit from increasing volatility.

Some will also do very well out of the problems currently being experienced by some quantitative funds.

That is the nature of the hedge fund industry. Typically, there are always some strategies or managers making money.

Some researchers and media are saying that no one saw these events coming and that they couldn’t possibly have known issues were looming for these high yield funds — the lesson or implication being that nothing can be done in trying to avoid future problems.

But, if true, why was it that most well-run, global fund of hedge fund and multi-managers had no holdings in the Basis funds at the time of the collapse?

While the extent and speed of the ‘blow up’ may have surprised everyone, and we all make mistakes, in this case the growing risks were apparent to a number of professional investment management groups that made the proactive decision not to invest or to exit investments some time ago.

The situation also raises questions about the set-up of the research industry. In particular, is it structured in a way that focuses attention on the key issues that advisers need to know in building portfolios for clients?

These days there are essentially two types of research house models. Those that charge fund managers to research product and those that charge subscribers, but that typically also have a separate multi-manager fund management capability.

Without even looking at the potential conflicts of the first, fund manager paid ratings model, or the quality of the research, the important point is that the research is almost totally focused on fund reviews and ratings given this is where most of the revenue is generated.

The other key elements in building a good investment portfolio, the actual allocation across funds, different risk profiles and altering these allocations across time given the dynamic investment environment, are largely neglected.

Ratings concentrate on a view of the manager’s ability to invest in a particular area or strategy — not whether (and how much) it actually makes sense to invest in the product/area now. Building a sound portfolio requires much more than a simple shopping list of four and five star funds from one of the research houses.

At first glance you would think the second type of research house would be in a much better position to actually cover these portfolio construction and investment strategy issues as well as recommendations on product.

Perhaps, but in recent years these groups (and there are two that dominate) have arguably become less focused on these areas and more on building their own multi-manager capability.

Given the current economics and the greater value attributed to funds management, it would be no surprise if fewer resources were being devoted to the subscriber-based clients and more to building up their own multi-manager capability.

In either case, it means that across the research industry there is probably insufficient effort being diverted towards initial and ongoing portfolio construction issues for financial planners and clients. It is then up to planners themselves and dealer groups to provide this, only a few of which are adequately resourced to do so.

Perhaps one key lesson from these fund problems is that more and better research on asset allocation and portfolio construction is required and should be demanded (and paid for) by advisers. It may not have prevented some of the problem funds being included in portfolios, but I suspect the proportion of investments in problem funds by these portfolios would have been significantly lower.

Fund ‘blow ups’ are a common feature of the hedge fund industry and there are almost certainly more to come out of the current turmoil.

However, there are plenty of blowups in conventional investment areas as well (eg, listed companies, property related investments). The aim is to avoid them or ensure that the positions are so small that they don’t permanently damage client portfolios.

Fund of hedge funds and multi-managers are ideally placed to prevent this occurring. For example, even a number of funds of hedge funds that had exposure to last year’s collapse of single strategy hedge fund manager Amaranth quickly shrugged it off and have done well.

That is not to downplay the current issues in financial markets that look like making August the worst month for hedge funds for a number of years.

However, this is exactly the sort of environment that is conducive to generating the very inefficiencies and opportunities that the better hedge funds can take advantage of going forward.

Rather than a time to look at cutting back exposure it may well be time to think about adding more. History shows that it is periods of distress, fund failures and dislocation that are the ideal times to add to hedge fund exposure.

For example, in the year after August 1998 (the month of the collapse of Long Term Capital Management) hedge fund returns as measured by the HFRI Composite Index returned 24 per cent, well above their normal expected returns. Of course, stepping up in the eye of the storm is not easy.

Indeed, there has also been no shortage of planners willing to come out in response and say they don’t use any hedge funds with some sort of childish ‘told you so’ sentiment. Their knowledge of what is actually going on in the hedge fund world seems just as immature.

In a recent article one planner who no longer uses hedge funds was quoted as saying “over the past two or three years in looking at returns and where the returns come from and what clients actually want, I can’t see them being able to deliver what they promise”.

My translation of this confused statement is: ‘Looking backwards, hedge funds have returned less than the share market, I don’t understand how they make their returns, my clients want high, double digit returns and I totally misunderstood what to expect from hedge fund returns.’

Referring specifically to fund of hedge funds, he is quoted as saying: “They might have a slightly lower level of risk than a one-style hedge fund, but with that layer of fees I don’t ever see them being able to achieve their objectives.”

Wrong! Fund of hedge funds inherently are clearly much lower risk than the vast majority of single funds and most well-run, fund of hedge funds have more than met their objectives in recent years, typically returning 2 to 4 per cent per annum over cash and bonds.

This sounds like the sort of planner who believes in the fantasy that equities and property trusts will continue to compound at 15 to 20 per cent per annum and probably has switched his hedge fund exposure there. (After all, he wouldn’t have switched them into cash or bonds because these have returned well below fund of hedge funds in recent years).

Obviously, downside risk also doesn’t seem to be an issue for such clients and raises the question of how clients fully invested (or geared) into equities and property are coping with the latest fall in share markets, with many funds down as much as 10 per cent from their highs and more specialist funds (eg, small caps and geared share funds) down as much as 20 per cent. Well-run, well-diversified fund of hedge funds, while not immune, are likely to be down in the low single digits.

The recent problems of Basis, Absolute and Macquarie Fortress, with perhaps more to come, has led to suggestions that some planning groups are becoming more reluctant to recommend hedge funds and other alternatives to clients and some may even consider withdrawing from them altogether.

While a review of portfolios may be necessary in response to the current turmoil (although prior would have been preferable) this should be on an objective investment basis, not a knee-jerk, business driven one.

As more dealer groups are looking to grow (and float) they have become more concerned about business risk and in some cases are overriding internal and external investment recommendations.

How can we expect this industry to stop bumbling from one investment crisis to another if it continually lets non-investment people make investment decisions?

Alternative investments are here to stay and will continue to be a vital (and increasing) component of many well-constructed investment portfolios, for both institutional and retail investors. Many good advisers recognise this.

However, as with mainstream investments, not all will perform and some alternative assets and specific products can be terrible investments if purchased at the wrong price, especially if heavily leveraged.

But I believe the correct outcome of a review is that many investors should have more conservative hedge fund exposure, (primarily via fund of hedge funds), not less, particularly given that history shows that these periods of market stress are actually the very best times to invest new money in hedge funds.

The broader lesson the world is learning once again is the danger of high leverage, particularly in relation to the risks and liquidity of the strategy or asset class.

Some hedge funds are part of this, but so are margin lenders, geared share funds, CFD providers, structured product issuers, aggressive banks and other lenders.

Heavily leveraged households and investors (and their advisers) have to also take much of the responsibility. An over-leveraged financial system built on faith that asset prices only ever go up is a recipe for disaster and we are currently seeing some of those consequences.

It is not yet known whether things will worsen dramatically and/or the flow-through effects to the real economy are significant, but the financial sector of the economy will almost certainly experience a shakeout as a result.

Clearly, the risk in the current environment is that some planners and investors act irrationally and in doing so make their client portfolios more concentrated and less efficient.

They may switch to mainstream investments they feel comfortable with, but which are actually vulnerable and make their clients portfolios less diversified.

At the same time, they may be withdrawing from, or at least neglecting, perfectly appropriate alternative investments, which are even better placed after this dislocation, to offer valuable diversification and return benefits.

While there are clearly some lessons to be learned from the current situation, they need to be the right ones.

This is a time for objective and balanced decision-making, not knee jerk emotional reactions that are detrimental to clients’ returns and may increase real (rather than perceived) risks considerably.

Dominic McCormick is the chief investment officer of Select Asset Management .