How to handle hedge fund investing

Whilst at GAIM, the world’s largest alternative investment & hedge fund conference, it was hard to ignore both the issues the hedge fund industry face and the opportunities from which they can profit. So how can you, as an investor, handle hedge fund investing? Be strategic, be sensible and speak up….

Fees – How can you challenge them?

Bigger isn’t always better. Instead it was the larger funds that had trouble liquidating large positions to meet redemptions in 2008 and this was amplified in Fund of Funds structures. The resulting side pockets and gates, which locked up investor capital, burned bridges. Therefore, funds merely offering access to large ‘star’ fund managers with limited attention to downside and liquidity risks no longer appear to be as wise an investment as once perceived.

A due diligence downfall.  Some funds of hedge funds had exposure to Madoff and other hedge fund failures. Therefore, ‘outsourcing’ hedge fund investment to a dedicated fund manager did not always reduce risk.

Strategy choice – Does it matter?

A ‘typical’ hedge fund does not exist. A hedge fund index is an artificial averaging of a wide range of performance data. In fact, over the past 2 years, the best performing hedge fund strategy has generated 160% more return than the worst. Yes, 160%! Even year to year the rankings change. By investing in completely different assets, implementing vastly different investment processes, hedge funds can perform in entirely different directions in a variety of market conditions.

Source: Hedge fund strategies ranked by performance each year, showing the variability in strategy leadership.

Value – How can hedge fund investments benefit your portfolio?

Well-equipped. With doubts over the sustainability of the ‘recovery’ in the developed world shaking equity markets; turmoil in the middle east creating volatility in commodities and the sovereign debt crisis rocking the bond markets, having a wider range of tools to exploit the uncertainty is valuable

A diversifier.  Widespread fear and the increase of speculators in certain markets has resulted in heightened correlation between asset classes, for example, equities and commodities have been moving inline…. An active manager who can provide uncorrelated returns to diversify a portfolio and steady the return profile again is attractive

Differentiating. In contrast, correlations between investments within each asset class are falling. The FT recently reported that the correlation between stocks in the S&P 500 index has fallen to levels not seen since June 2007. This means there is a widening divergence between returns.  Therefore, the ability to differentiate between opportunities within a subset is a strength of active over passive investing.

So what can you do?

Be strategic: strategy choice matters so utilize your views on the macroeconomic environment to help determine which strategies in which to invest

Be sensible: ensure funds deserve the fees they are charging, e.g. are focused on portfolio construction, generating returns from niche strategies, and structured appropriately with the redemption frequency matching the liquidity of the underlying investments.

Speak up: it is as important for BOTH sides to manage expectations to avoid redemptions from investors, and side pockets from funds.


Hedge Funds – to be Feared or Favoured?

As the biggest hedge fund insider trading case comes to a close, we are reminded of the risks of investing in the asset class. Ever since generating losses in 2008, the reputation of these ‘absolute return’ vehicles has been damaged. The Madoff scandal which topped off the year did not help. Nevertheless, whilst clarity in the markets remains illusive and with a wider range of tools to exploit opportunities, are they a form of investment to be feared or favoured?

A Tainted Asset Class

Disappointed and disillusioned, many investors are reluctant to revisit the asset class run by managers once hailed as the new “masters of the universe”. Sold on the promise of generating positive performance in any market environment or at the very least preserving capital in times of stress, losses generated in 2008 came as a shock. With the Madoff scandal came the realization that even funds that did consistently generate steady returns were not immune to trouble. There is even an aptly named “Hedge Fund Implode-o-Meter” website tracking the number of major funds which have “imploded” since late 2006 (out of interest the number at last look stands at 117, although this includes all funds suffering any form of “permanent adverse change”, not just total shutdown).

But Not All Are Created Equal

Not all hedge funds should be tarred with the same brush and although grouped within the same category, they can differ tremendously. From the investment vehicles in which they invest to the stringency of their risk management, not all are created equal. The Hedge Fund Association summed the situation up succinctly with the assertion that “investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.”

Losses Were Often Greater Elsewhere

Putting aside the often misleading ‘absolute return’ banner, the average hedge fund was better able to preserve capital through the market downturn than a regular ‘long-only’ mutual fund. Whilst the MSCI World Index fell 42% in 2008, the Credit/Suisse Tremont Hedge Fund Index fell 19%, More impressive still were the 21% of funds which posted positive returns for the year (the majority of which were up double digits). Crucially, over a more appropriate investment horizon of 3 years, according to figures by EDHEC Business School, “The majority of hedge funds delivered better returns than the S&P 500 index”. Hedge Funds have shown themselves able of generating highly attractive returns.

The Tide Has Changed

Investors have demanded more. In 2008 they ‘spoke with their feet’ and the hedge fund industry suffered $782bn of redemptions. The Hedge Funds had to listen. What was requested, according to a report by Scorpio Partnership, was “transparency, simplicity and liquidity”. Likewise, the Hedge Fund Scandals were a wake up call to investors and much more focus is being placed on operational due diligence, to avoid investing in any future hedge fund failures.

Investment Insight: Well-Positioned to Exploit Opportunities

With the risk of future macro shocks clouding the horizon (read: Japan, Middle East, EU Sovereign Debt), the direction of the markets is somewhat hard to predict. Therefore investing with flexible managers able to react to the quickly changing environment and nimble enough to exploit opportunities when they present themselves seems an attractive move. Not all investments are created equal, some are more equal than others.