Is the emperor wearing clothes?

Norman Chait argues that hedge funds should again perform their traditional role of providing genuine sources of non-correlated returns and downside protections

Hedge funds until recently were lauded as the royalty of the investment world, providing solid risk-adjusted performance celebrated by all, often at lavish awards events where the managers would (at least figuratively speaking) parade in full ceremonial regalia.

This was until last year when, despite flexible investment mandates, hedge funds as a group were unable to provide downside protection. The HFRX (Investible) Global Hedge Fund index and CS-Tremont Hedge Fund index lost 23.35% and 19.07% respectively in 2008, and have only recovered a fraction of this so far in 2009.

So does the emperor have any clothes? Are hedge funds really what they had been made out to be, or is the naked truth far less majestic? How should one invest in hedge funds going forward and what should their role be in a diversified portfolio that includes traditional assets?

Performance - is there any?

A recent Barron’s article listed the top 100 performing hedge funds over the one-year and three-year periods to year-end 2008. Many observers focus on the star performers, and are infatuated by over-analysing short-term winners and the drivers of their success. While no doubt many of these hedge funds are fine firms, there are always cyclical factors that drive such returns, and last year was no exception. CTAs and other long-volatility strategies were disproportionately represented in a year when global markets experienced precipitous drops.

What caught our eye was not the top of the Barron’s list, but rather the bottom. Most notably, the one-hundredth best performing hedge fund had a three-year compounded annualised average return of 8.25%. If so, then the other 5,900 or 6,900 hedge funds out there fared worse. In fact, the three-year compounded average return of the CS-Tremont Index Hedge Fund index (assuming it is indeed representative) was a meagre 1.25%. One would have been better off remaining in cash.

Hedge fund managers enjoy one of the most attractive incentive schemes in modern commerce. This includes not only performance fees, but also high management fees, which are often a generous source of profits too. Moreover, there are also other liberal ‘fund-related expenses’, in some cases not dissimilar to those claimed by UK parliamentarians, and which have been the source of public outcry. Nevertheless, only a select few managers have been able to provide decent returns to their investors of late.

We deduce from the performance numbers listed above that to achieve the 8-9% annualised target return that most endowments and foundations require, one would have to select the top 100 hedge funds managers consistently. This is less than 2% of the total manager universe, or a lower probability than picking a single number correctly on a 37-number roulette table.

With the average large fund of fund having 50-100 underlying investments, all the major players would have to be invested in the same hedge funds - and if this was the case, who would be left to invest in the remaining 98.5%? 

This sobering revelation leads to the age old question of how to consider hedge funds as investments. We have had a clear view on this ever since the turn of the century, when the hedge fund industry started to experience explosive growth - we believe that hedge funds are not an asset class, they are a talent pool. And we submit that using traditional asset allocation and analytical techniques to evaluate and handicap hedge funds is an ineffective exercise.

The drawbacks of the traditional quantitative approach to discovering managers was brought to the fore a couple of years ago, when I oversaw hedge fund sourcing for a large wealth management firm. The next row on the trading floor was populated by a group of highly intelligent PhDs in quantitative disciplines.

One esteemed doctoral colleague challenged us in turn that he could uncover a superior group of hedge fund managers purely using proprietary data screening techniques than we could simply based on our experience and industry sources. His top 10 list was indeed impressive, although we had to point out to him that one of the managers was deceased. 

How not to integrate hedge funds into a portfolio

Uncovering investment talent is only one part of the puzzle. The next piece to consider is how quality hedge funds should complement a diversified portfolio which includes traditional assets.

We have observed that most portfolios of hedge funds are created and calibrated as a total portfolio solution on a standalone basis. There are many commercial reasons for this, including that fund of funds need to demonstrate a consistent track record in order to raise assets successfully. There is, therefore, an incentive to capture positive beta in rising markets, which may be at the expense of providing downside protection or effective diversification to the overall portfolio.

We believe that hedge funds should diversify away from, rather than into, the other asset classes in a portfolio. Unfortunately, what often happens is that managers, in an attempt to provide portfolio balance, encroach upon and neutralise other sources of traditional beta. Let us illustrate this with a simplified example:

An endowment has a 10% allocation to US equities and follows an efficient markets approach. It invests in an index fund for 17 basis points per annum. It then allocates an additional 10% of its overall portfolio to an equity long-short fund of funds for which it pays a 1% management fee and a 10% performance fee. This is in addition to the 2% management and 20% performance fees payable to the underlying hedge fund managers. These managers are on average 150% long their favourite stocks, but are not able to find sufficiently attractive individual equity shorts. Hence, in order to mitigate market risk, they short 100% of their net asset value in S&P500 futures, for a 50% net long exposure .

However, in doing so, the managers have neutralised the long beta exposure of the endowment’s passive US equity allocation. After netting out everything, the endowment is left with 1.5 times levered long-only exposure for which it pays a cumulative 3% management fee and 30% performance fee. In a good market environment, most of the advantage of the leverage is eaten away by the high aggregate fees. In a poor market, no protection is offered.

Some portfolio construction experts will argue that even if the hedge fund of funds portfolio neutralises the index exposure as described above, we should ignore this, as each part of the portfolio should be analysed according to its separate performance goals. But if each component of a portfolio is designed for a different purpose, then surely they should complement rather than neutralise one another.

What next?

We offer a three-part suggestion. First and foremost we propose that investors should focus only on talented managers, even if leads to a smaller absolute number of hedge funds in the portfolio. We are willing to pay incentive fees for true alpha generation. 

Second, these funds should either provide effective downside protection, or be completely uncorrelated to traditional asset classes with no market beta exposure.

Third, the absolute short-term performance of the hedge fund sub-portfolio is less important than the role it plays in the overall portfolio. Put differently, hedge funds should outperform traditional assets in flat or down markets, providing portfolio protection in the latter scenario. It is not the end of the world if they underperform in sharply rising markets where the overall portfolio performs well. The sub-portfolio of hedge funds should not be evaluated in isolation. 

The year 2008 not a good one for absolute return products. As we noted above, from a probability standpoint one was better off chancing the betting tables in Vegas than trying to pick the best managers.

We look forward to an era where hedge funds once again perform their traditional role of providing genuine sources of non-correlation, or affording portfolio protection, outperforming in flat to down markets while underperforming somewhat in strongly rising markets. We believe that most multi-manager hedge fund portfolios are not positioned with this in mind. Many suffer from subconscious market beta creep.

As such, we submit that institutions which also have exposure to long-only assets classes, may want to take a more selective approach to investing in hedge funds. Less may indeed be more.

This takes us back to our initial question, does the emperor have any clothes? Perhaps the really talented few indeed do; however, it includes a lot of protective gear.


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