Big baby faces teething troubles
Suddenly, every one seems to be a hedge fund expert. Fund of funds managers, hedge fund analysts and new hedge fund managers have sprung up like mushrooms, drawn by the inexorable emergence of a multi-trillion-dollar industry that some believe seems set to evolve overnight. The omens are indeed promising. But, in reality, the industry is facing a host of teething problems, as baby passes into infancy on the long haul towards full maturity.
In its relatively short history, the industry has been fuelled by assets gathered from high-net-worth individuals. Family offices and the now ubiquitous funds of funds, run largely by private banks, have provided the mainstay of investment. These investors want capital protection and annualised compound returns unlinked to market performance, but targeted at an absolute return objective somewhere in excess of the risk-free rate. The absolute return concept has recently enjoyed a groundswell of support.
Now that the institutional fund management groups are clambering on to the band wagon with these new hedge fund offerings, largely for more sophisticated high-net-worth clients, there is a widely held belief that hedge funds will find themselves becoming more attractive to plan sponsors and pension fund managers. Despite the well-documented cultural difficulties for traditional asset management firms, plus the fact that the size of such funds tends to be inversely proportionate to their ability to generate returns, many institutional names have built huge alternative investment businesses within months. This is a cause for concern.
But how to get objective advice and just what are the impediments to the plan sponsor? In the UK, in recent weeks, serious criticism was meted out to one of the leading consulting firms for awarding a hedge fund mandate to a new multi-manager group without going through any of the conventional RFP procedure. After several years of incredible returns from private equity funds, it seems that Swiss Air Pilots Fund and ABP in the Netherlands will make substantial allocations to alternatives this year. Intellectually, the case may be compelling, but are the risks really worth taking? We set out some of the reasons why plan sponsors should be wary of leaping into alternatives.
q Hedge funds remain unregulated. In the US, pension funds have remained largely absent from the hedge fund arena over the past 20 years. The Employee Retirement Income Security Act (ERISA) set a standard for prudent investing that underscores fiduciary caution when considering hedge funds. This has been echoed by the recent Myners Report in the UK. The advent of the institutionally sponsored hedge funds may go some way towards allaying concerns over the intrinsic risks long associated with the proverbial ‘two guys and a log cabin’ characteristics of the industry, but the insurmountable risks can still be attributed to the unregulated nature of the funds.
q Hedge funds can offer risk reduction if you define risk in terms of volatility of returns. However, in many other ways, they are much riskier than traditional funds. Professionally optimised funds of funds can diversify away much of the risk of being concentrated in too few strategies but few of the new exponents have the proven credentials to understand or analyse hedge fund risks, a problem compounded by the fact that even if they do, it is not easy to gain depth of insight into these often secretive businesses unless you are already an investor. Even then it is not guaranteed.
q Detailed attribution analysis is not simply a means of boasting how returns have been attained. It is a valuable tool for evaluating concentrations of risk within a portfolio, and measuring to what extent the aggregate exposure of your fund of funds is vulnerable to one particular stock, sector or economic variable. There are few fund of funds exponents who are genuinely equipped to make use of this information once they have it, and run scenario analyses on their portfolio of funds to get an understanding of how its volatility characteristics could be vulnerable to any of a host of variables.
q Hedge fund managers do not welcome investors who trade in and out of their funds. Institutional investors, which are usually constrained by benchmarks, and fund of funds, susceptible to the whims of their underlying investors, are often perceived as undesirable for this reason.
q Although trading in funds is increasingly done over the counter (OTC), getting exposure to managers with which you are comfortable, and have the requisite information to make an informed investment, is becoming more and more difficult. The hedge fund industry has been largely hostile to the new trading platform initiatives, offering transparency and liquidity, and consequently none has made its mark to date. Unless backed by a proprietary fund of funds or private banking flow-through, most seem destined to whither on the vine, making circuitous access not a real option.
q Leverage is widely discussed in hedge fund circles. Many are keen to see low net exposure to the market. However, it is more often than not the gross balance sheet that is the cause for concern. A fund of funds may be running a market neutral book, but have 150% long and 150% short. Such a portfolio would be 300% leveraged, and significantly more risky than a fund with the same net exposure that is 50% long and 50% short. What may seem obvious is often ignored. Should the markets move with a long beta that does not match that of the shorts, losses may be amplified in a geared portfolio. What is more, the risk characteristics of a short versus a long are already very different. A short that goes wrong carries the risk of unlimited losses on the upside, whereas a long can only fall by the value of the asset. A short that goes up becomes a larger part of your portfolio, whilst a long position that falls is commensurate with smaller overall risk, as the size of the position relative to the fund diminishes. This has to be monitored constantly.
q Traditional consultants, as previously mentioned, are not equipped to help the pension fund manager monitor the unorthodox risks associated with alternative asset management. Furthermore, the transaction-driven hedge fund promoters and on-line exchanges, which style themselves providers of research, all suffer from compromised objectivity. Even the fund managers themselves can be expected to gloss over the risks within their strategy, if greater transparency might result in losing assets under management. Ultimately, many hedge funds may simply not want institutional investors who demand higher levels of scrutiny and disclosure.
Some commentators believe that the entry of institutions into the hedge fund arena will spoil the party for the high-net-worth investor, gobbling up limited capacity while dictating a more regulated and restrictive regime. They warn that the proliferation of hedge funds and the entry of institutional investors may close the gap on the very arbitrage opportunity that is the hedge fund’s raison d’etre. Investible hedge fund indices, principal protected guaranteed products and the enormous number of new funds of funds, are just some of the phenomena likely to lead to increased competition for the better hedge funds and a deterioration of the mean against all are measured. Ironically, attempts to benchmark the industry, to make it more palatable to the institutional investor, run counter to the very notion of absolute return investing.
Simon Hopkins is managing director at fund analytical service Global Fund Analysis in London