May 2007: Unravelling the mystery of hedge funds

For many planners, hedge funds have been an area of intrigue and caution; intrigue because the industry has many interesting strategies and is full of characters, caution because of perceived risks, and also because it is difficult to explain hedge funds to clients and the role they can play in client portfolios.

Just like any other actively managed investment product, hedge funds are all about active returns.

However, the active returns are a little bit harder to identify. It is important you can identify what part of the return is active return versus the component which is related to the market exposure in the portfolio.

Just like traditional asset managers, some hedge fund managers produce positive active returns and some negative.

A diversified pool of hedge funds (for example, a fund of funds) is a candidate for the defensive part of a client’s portfolio, more so than the growth portion of the portfolio.

A diversified portfolio of hedge funds is likely to have modest exposure to equity and credit market movements and a diversified pool of active return styles. This means it should be considered against asset classes such as bonds.

What is a hedge fund?

Hedge funds are built on the same principal components (DNA) as all financial products.

Hedge funds, like all financial products, can be viewed as a collection of market exposure biases and active return strategies. Once put into this framework it becomes much easier to understand the performance profile of hedge funds and how to use them effectively within diversified portfolios.

If one thinks of hedge funds as absolute return products it all becomes much more difficult.

We believe there is an underlying logic for why hedge funds exist. Do you believe that:

1. Markets are not perfectly efficient?;

2. Active management can produce excess returns to those generated by the market?; or

3. By increasing flexibility and removing constraints, skilled managers have the potential to produce greater levels of active returns?

If your answers to number one and two are ‘yes’ then you should consider actively managed products, otherwise you should use only index funds.

However, number three is the next extension, suggesting that benchmarks and other constraints restrict managers’ opportunities.

If you agree, then hedge funds should be further investigated. The underlying principle of hedge funds is that a greater amount of flexibility increases the potential for active returns in inefficient markets — including more active use of leverage, derivatives and short selling, while an index agnostic approach also removes a key constraint.

The key reason that hedge funds exist is flexibility. As can be seen in Diagram 1, hedge fund managers benefit from fewer investment constraints, allowing them to concentrate on the best ways for them to manage their portfolio.

It is important to understand that this logic is not a guarantee that all hedge fund managers will generate active returns. Just like traditional managers, not all hedge fund managers have an investment edge.

There are many different hedge fund strategies.

The objective of this article is not to explain each to you. They will have different market exposures and differing styles of active returns.

Where do all these strategies come from? Places that most people are already familiar with, as presented in Diagram 2 (on page 17 of Technical adviser May 2007).

There are a number of myths and realities surrounding hedge funds. A few of these are explored in more detail.

Myth 1: the absolute return myth

The potential of hedge funds is regularly misunderstood because many people call hedge funds ‘absolute return funds’.

The term ‘absolute return’ is a myth. The best definition of an absolute return is a very high likelihood of achieving a certain level of return regardless of the market environment.

Increased flexibility does aid alpha opportunities, while underlying market beta does exist and cannot be avoided within hedge funds.

The challenge for the investor is to understand this to enable them to more readily appraise performance.

All investment products are a combination of market exposures and active return exposures (see table 1 on page 16 of Technical adviser May 2007).).

Market exposures are familiar, and common to both traditional products and hedge fund products.

The net sum of market exposures will always be 100 per cent. It is a simple accounting fact that market exposure cannot be created or destroyed, that is, if the investor gives a manager $1 they must invest $1 net, not $1.50 or $0.80.

So, if a hedge fund has a bias to a particular market(s), how can it perform just as well in any particular environment? It can’t and so the term ‘absolute return’ is a little misleading.

Briefly, it is important to explain the different styles of active returns:

Alpha — security selection: Selecting stocks or credit securities which outperform the broader market over time is a source of-added value. Shorting stocks that underperform the market is another source of added value. An example could be holding shares in BHP and these outperform the broader market.

Alpha — security mispricing: Capturing perceived mispricings between similar or related securities. Often, because markets are reasonably efficient, the mispricing opportunity is small and leverage needs to be used at a portfolio level. An example could be capturing the perceived mispricing between two state government bonds.

Market timing: Taking directional views on overall market movements in equities, fixed income, currencies or commodities. For example, one may believe the Australian dollar will rise against the US dollar.

For single market traditional products such as an Australian share fund, there is usually only one market exposure, and for multi-sector traditional products, a range (all positive).

Hedge funds are a little more complex as they frequently involve techniques such as short-selling, leverage and the use of derivatives, for example, a fund that is 200 per cent exposed to equities is leveraged and is short cash (-100 per cent exposed to cash). The exposures still net to 100 per cent. They may have a variety of underlying market biases.

There are some significant implications that come from understanding and accepting a philosophy like this:

> You can gauge whether a manager is adding value or not (that is, is the manager producing positive active returns) and

> You can now work out how hedge funds better fit in a portfolio.

So, for example, if a hedge fund has a long bias to equities over time, then all else being equal this fund is more likely to perform well when equity markets are strong.

Hedge fund returns are dependent on market returns — it is not correct to label them absolute return funds.

Myth 2: leverage

Many people think that all hedge funds use large amounts of leverage. This is not true. Some hedge funds, likely less than 10 per cent of the universe, do use a large amount of leverage. However, they will generally manage this sensibly and generally will usually be investing in very liquid securities.

Many of the adverse hedge fund headline events over the years have been due to the combination of leverage and illiquidity. This is one of the key risk areas to focus on.

Myth 3: transparency

Many people think all hedge fund managers provide very little transparency. This isn’t the case. A large majority of managers are very transparent. Some managers provide less transparency because they feel they have an edge and they are trying to preserve it.

The main risks of hedge funds

There are a number of broad risks that could adversely impact hedge fund returns:

Market returns: Hedge funds have some market exposure (as explained previously). Markets do experience periods of poor performance and this could affect the total hedge fund return.

Active returns: Just because hedge fund managers are trying to generate active returns doesn’t mean they will be successful. Indeed, many managers experience negative active returns and this will affect the total performance outcome.

The timeframe for investment is obviously important; if you invest in a quality manager for the medium-term (three to five years) then it is likely to achieve the active returns it expected, compared with making short-term assessments.

There are four other risks that need to be screened for via a thorough due diligence process.

1. Operational risk: This includes the potential for underlying managers to operate outside of their usual investment and business practices. The most extreme operational outcome is fraud.

2. Liquidity risk: This is the risk of hedge fund managers not being able to meet the liquidity demands of their equity and debt providers. Liquidity risk is not exclusive to hedge funds. There have been well-known cases of traditional investment managers experiencing severe difficulties because they cannot deliver the necessary liquidity. However, because hedge fund managers can use leverage the potential is increased.

3. Business risk: This is the risk that the hedge fund management company fails, resulting in the closure of the hedge fund. This does not mean investors lose any money. The key risk is that the portfolio manager’s behaviour may change as the manager could be more desperate to produce large results.

4. Key person risk: This is the risk that key staff may leave the underlying hedge fund, resulting in a lower quality management team.

Fund of funds approach

A fund of funds hedge fund (fund of funds) is a fund which invests in a number of underlying hedge funds. A fund of funds manager actively selects the hedge fund managers to be included in the portfolio and manages the finance, legal, taxation and administration issues involved in the construction and ongoing management of the fund of funds.

If one agrees with the logic of hedge funds, consider the following statements about a fund of funds.

1. Because hedge funds have greater flexibility, there are many different styles and strategies. It requires specialist skills to assess both the strategy and the skill of the hedge fund manager.

2. Some hedge funds close their doors to new investors relatively quickly. It takes significant resources to continue to identify quality investment opportunities.

3. Because there are many strategies and styles and sources of return, hedge funds can perform a variable role in a diversified portfolio. A fund of funds approach can make the sources of risk and return more consistent, allowing one to better understand the role that hedge funds can play in a diversified portfolio.

If you agree with each of these points then you understand the value proposition of a fund of funds approach to hedge fund investing.

The key functions of a funds of funds approach are presented in Diagram 3 (on page 18 of Technical adviser May 2007)..

A fund of funds (FoF) will tend to have relatively consistent market exposures because it is a diversified exposure to the market biases of the underlying managers, which in aggregate changes little over time.

The biases will vary a little more if the FoF manager tactically allocates between different hedge fund strategies.

As a case study, a FoF could have market exposure biases of:

> 5 per cent high yield credit;

> 15 per cent global equity; and

> 80 per cent cash.

So what level of returns is achievable?

This depends on what level of active returns is reasonable to expect.

If hedge funds are all about active returns then this becomes the key question. It is important to be realistic. Active returns are hard to find in a competitive market. Hedge fund managers have some structural advantages over traditional managers that may assist them if they use this properly. But there is now a huge amount of capital flowing into the hedge fund industry that further increases the competition for active returns.

Given the diversification a FoF targets, it would be reasonable to consider that a good result is 2 per cent active return after fees and a very good result for the investor is a 4 per cent active return after fees.

This may or may not sound exciting. It is exciting compared to the active returns that have been achieved in traditional products such as Australian fixed interest, Australian and global shares, though one can always highlight single managers that have outperformed in these spaces.

It is also attractive when the low volatility of FoF performance is taken into account. However, it is not consistent with the hype that some associate with the hedge funds industry.

So now, armed with an understanding of market biases and active return expectations, we can consider what would be deemed half way between ‘good’ and ‘very good’ performance for a FoF in different environments.

Note that each number in the matrix (see table 2 on page 18 of Technical adviser May 2007).) is different but represents the same active return result. This matrix highlights how market returns can affect the return of a FoF.

Portfolio construction using hedge funds

So, what is the best way to incorporate hedge funds into a client’s diversified investment portfolio?

The first recommendation is do not use hedge funds unless you feel comfortable with them. In terms of education a number of product providers provide education courses which may bring planning groups up to an appropriate level of understanding.

Which part of the portfolio?

Given the market exposure profile of the case study FoF used in this article (5 per cent high yield credit, 15 per cent global equities and 80 per cent cash), it is appropriate to compare this against other defensive investment opportunities, such as cash, bonds, mortgages and diversified credit. To compare each the following questions should be asked:

1. What is the underlying asset class income of the opportunity?

2. What are the risks associated with the underlying market exposures?

3. What is the potential level of active returns?

4. What risks are associated with the active return exposure?

Analysed in a framework like this, a diversified FoF is an attractive investment because the active return profile is larger than what is usually available in traditional defensive asset classes. As the active return opportunity is larger, and alpha is lowly correlated with returns of asset classes, this is a very valuable diversifier for portfolios.

The key proviso is recognising that a FoF will typically offer less liquidity than traditional defensive asset classes. This needs to be taken into account with respect to each client’s unique liquidity requirements.

The same framework can be applied to incorporating individual hedge funds in a portfolio. That framework entails:

> understanding the market exposure biases;

> Understand the active return style, risk and potential;

> Determine whether this fits in the defensive or growth portion of a portfolio (are the underlying market biases growth or defensive);

> Assess whether the active return opportunity is greater in the hedge fund compared to other opportunities available.

This framework is interesting as the result could be that different hedge fund managers belong in different parts of the portfolio.

There is greater selection risk in taking a single manager approach. What may appear an exciting strategy may actually be well behind peers.

A FoF team will have specialists who know their peer space very well. They should also be able to identify and assess the key sources of risk very well.

For this reason, we encourage planners to use a FoF approach rather than individual hedge funds, particularly when they are seeking diversification benefits rather then exposure to particular asset classes.

Summary

Hedge funds are very interesting for their active return potential. A FoF approach can be a good way to access the return potential of hedge funds, as individual manager risks are expertly assessed and diversified.

A FoF can potentially be a useful part of the defensive portion of a client’s diversified portfolio; but you must be aware that there is less liquidity.

Using individual hedge funds is more complex and different strategies may belong in different parts of the portfolio.

David Bell heads ColonialFirstState Global Asset Management’s hedge funds team.