The level and nature of coverage of hedge funds in the mainstream international press in recent months has passed beyond hype and moved into the realms of hysteria. The atmosphere is reminiscent of the good-old, bad-old days of the dotcom boom, though the hedge fund industry would reject the comparison. This is not an unsustainable boom, it declaims, this is not an over-inflated bubble.
Cynical observers would respond to such protests with the classic Mandy Rice Davies dismissal – “they would say that, wouldn’t they?” And they do seem to have a point. The consensus is that hedge funds might well have been overexposed, but certainly underexplained. Like Big Brother in George Orwell’s 1984, to know them is to love them.
The debunking of myths, for instance, makes an excellent starting point for a considered examination. Myth number one is that hedge funds are very risky. But how can this be when the first rule of hedge funds is ‘lose no money’?
“Hedge funds all have different returns and characteristics, just as mutual funds and unit trusts do,” says Scott MacDonald, a director of Mellon Global Alternative Investments. “But the only interesting stories seem to be ones where people either make a lot of money or lose a lot of money, and that’s
what people tend to associate hedge funds with. Most are conservatively run. Of course there are risky hedge funds, but not the ones we invest in.”
Antoine Josserand, director, structured and alternative investments, at AXA Investment Managers says: “Hedge funds are not a panacea, but are de-correlated from other forms of investment methodology The flexibility they offer to active managers to invest using tools not available to ‘normal’ fund managers makes them an attractive means of enhancing returns.”
“Long-Term Capital Management is always wheeled out as an example,” observes Chris Woods, chief investment officer, hedge fund strategies, at State Street Global Advisors. “The truth is that equity is risky. Equity has destroyed a few pension funds and, conceivably, a few companies. If risk is defined as not being able to pay pensions, hedge funds have to be measured against equities, and hedge funds have the edge. It’s hard to see the kind of overvaluation we have seen in equities happening with hedge funds.”
Eric Bissonnier, partner and CIO Europe and Asia, EIM Group, agrees. “In some manifestations they can be risky vehicles, but when used to reduce risk by using a manager’s skills, they are less risky than equity, which can fall to zero. Few are as volatile as the FTSE100. It is more a matter of perception than of fact.”
As Nadja Pinnavaia, head of Goldman Sachs Asset Management hedge fund strategies for Europe, puts it: “Hedge funds as investment vehicles have historically suffered a bad image and negative PR; in the past certain investors have not had hedge funds explained to them accurately. A well-diversified hedge fund portfolio tends to be low-risk, and targets absolute returns under a variety of market conditions.”
Some of the risks seen in hedge funds are a fear of the unknown, adds Chris Mansi, senior investment consultant and head of the worldwide hedge fund research team at Watson Wyatt. “But looking at the return streams, a portfolio of equities can be much more volatile than a portfolio of a number of hedge funds.”
Taking the comparison with equity-long investment strategies one step further, one market participant went so far as to float the notion that these have destroyed so much value in recent years that pension funds should be banned from using them and forced either to use hedge funds or adopt hedge fund-style philosophies. While intellectually provocative, others agreed that this was on balance probably a step too far – though only because of the compulsion element.
Stuart Feffer, managing director at Bearing Point’s alternative investment practice adds: “If anything, operational risk centred on fraud, misrepresentation, and flawed systems or procedures is almost as much of an issue as excessive investment risk. Although even the SEC concedes that fraud is no more likely in hedge funds than in other forms of pooled investment.”
Myth number two is that hedge funds have hit a capacity ceiling in investment opportunities and managerial talent. Although this might be the case with particular strategies (convertible bond arbitrage, for instance) where too many hedge funds are doing the same deals and chasing the same targets, those strategies will inevitably lose their raison d’être, wane in popularity and be replaced by new ones as part of the market’s natural evolution.
Capacity will also, admittedly, become more of an issue where a popular manager is inundated with so much cash as to be unable to pursue the strategies that attracted the cash without diluting the return. As Watson Wyatt’s Mansi sees it, the industry could not necessarily cope with current rates of growth if these were to continue for several more years. Even so, in those isolated pockets where market capacity could be a legitimate concern in the medium term, the best managers resist the temptation to keep topping up on assets and put a strict cap on the total inflow they will allow. Selection of a manager suggests itself as the most important issue, as in every other field of investment endeavour.
But the flow of talent is not currently a constraint on the market’s development and growth. “Hedge funds are full of innovative people with new ideas,” says SSGA’s Woods. “The market is in a state of continual flux; managers come and go, strategies come and go.” It is certainly easier to start a hedge fund today than it was several years ago, according to Bissonnier of EIM Group. “We see no manager capacity issue where a firm has the necessary infrastructure, resources and processes. We need two to four new managers a month, and I would consider it extraordinary not to be able to find them out of the 10 to 25 managers we visit each week.”
Myth number three is that hedge funds lack transparency. “This always comes up as a reason for pension fund trustees taking a decision not to invest in hedge funds,“ says Woods. “The reality is that pension funds demand more transparency than they need, and hedge funds disclose less than they could. A happy medium could be struck. Instant transparency on every single movement is too much to ask for, and absolutely useless in any event because turnover can be so rapid.
But they could show clients some positions even if subject to a confidentiality agreement.” A good working relationship with the investment manager is the key here, he argues.
In the interests of balance, though, the final word goes to Mark Mobius, a managing director at Templeton Investments.
“Hedge funds are wonderful for the manager,” he says. “They have very lucrative fees, higher than the normal mutual fund, have complete freedom to do what they think is right in their investment strategy and banks and brokers
are making a lot of money out of their activities. And they do sometimes produce terrific results, which is why investors find them attractive.
“However, I am afraid there is a survivor bias in reported results, and I would ask whether the various indices reflect this survivor bias. Many funds go quietly out of existence with no publicity. And there is a fear that we may have a problem in the future. The original idea of hedge funds was to hedge risk and in some cases this has been abused. People are doing all kinds of things that have nothing to do with hedging.”
Despite these not insignificant caveats, even Mobius believes pension funds should probably make use of hedge funds, albeit through the indirect route of funds of hedge funds. And only after taking the advice of a good consultant, and proceeding carefully, exercising even more than the usual proper due diligence. But then, shouldn’t they do that with any investment?