Why worthy of closer consideration
The traditional attack on hedge funds has largely been focused on the unregulated environment in which they operate and, following the collapse of LTCM, the use of leverage and derivatives. It is not hard to see why the popular view is that hedge funds must be inherently risky.
Yet we find in the US that even the most conservative of institutional/high net worth investors have allocated large parts of their portfolios to hedge funds and other alternative investments. With over $500bn (E494bn) invested, can these investors have missed the point?
Hedge funds are not a new phenomenon. Alfred Jones is widely acclaimed to have been the founder of the industry in 1952, although leading Wall Street investment houses will claim that they have been running merger arbitrage books from the late 1930s. Jones observed that if you are screening a universe of stocks for great buying opportunities you are likely to come across those stocks whose valuations are suspect and likely to fall. He therefore developed the concept of going $1 long of great stock picks and shorting $1 of fundamentally flawed stocks.
In rising markets he determined that you would make money from the long positions giving up some of the gain for the short positions, the latter being viewed as paying a premium for downside protection. In down markets one would expect seriously flawed stocks to fall like a brick and whilst solid stocks would fall, their decline would not be at the same rate. It was therefore possible to make money in rising and falling markets.
In fact Jones’s performance was impressive – his Limited Fund Partnership outperformed traditional funds by 44% over five years and 87% over 10 years (source: Fortune Magazine, 1966).
So, what are hedge funds? They are actively managed funds run by the smartest money management talent in the asset management business, who have fulfilled their ambitions to:
o be independent – arguing that stock picking talent really does not require an institutional umbrella;
o have the ability to trade the entire universe of stocks and not be hamstrung by only being allowed to invest in long positions;
o take short positions either to offset their long positions (hence the term ‘hedge’) or purely to benefit from a directional position in falling markets;
o use derivatives to enhance market returns or to transfer market risk;
o borrow cash to be able to leverage their exposure to the markets;
o increase cash in times of crises; and
o be properly incentivised to deliver an absolute return.
In essence, traditional long-only fund managers operate in only one dimension, that of taking a long directional position. Even if they get that directional view right, they have no means of increasing their returns using leverage. A hedge fund, on the other hand, is like playing three-dimensional chess, using:
o long positions;
o short positions; and
o leverage and cash.
Therefore, a hedge fund manager has far more opportunity to extract returns from the market – both from a directional and an arbitrage perspective.
But there is a paradox. With their increased flexibility, hedge funds often offer less risk per unit of return when compared to their more risky long-only counterparts, and this is reflected in the superior Sharpe ratios displayed by many quality hedge funds.
Long-only managers find themselves entrapped by the structure of their industry. First, their performance is measured against a benchmark, usually the underlying equity or bond index.
Secondly, rewards tend to be structured around assets under management, as well as performance against the benchmark and not the absolute return. The more successful the players – the greater the assets under management and the liquidity constraints – which invariably means that long-only managers are chasing the largest stocks in their universe.
So here we see a number of issues – if all managers are measured against the relevant index it is likely that they will tend to manage their portfolios against a similar basket of stocks for fear of getting it wrong if they deviate from the benchmark list of stocks. Incentives are not tied to real performance and, as a result, negative performance that is slightly better than the benchmark is viewed as being successful.
Can these long-only fund managers achieve significant and consistent out performance of the benchmark over long periods of time? In general terms, the answer appears to be no. How often do we see changes in the league tables? Just about every funds award function?
This is not to say that you will not find great stock pickers and active managers in the long-only industry – you most definitely will – but it is likely that they are niche operators with small assets under management. When you get to $1bn plus funds under management, it is more likely that they will gravitate towards being closet indexers. In truth, due to their increased size, they have no option but to become closet index trackers, as their flexibility has to be monitored in relation to the liquidity of their investment positions.
Market action over the last three years is now challenging the conventional wisdom of long-only managers.
Does staying fully invested in equities for the long term really deliver superior returns to cash, bonds, real estate and other asset classes? History has only really supported this argument in the greatest bull market in all of history – 1982 through 2000. There are very long periods in history that do not support this view – looking at the Dow Jones index, we find the following:
There is, therefore, only one extended period where equities outperformed cash and bonds (but not property), the biggest bull market in history 1982-2000. But one has to ask the question – how much of this gain will be intact when potentially the longest bear market in history unwinds?
On the other hand, within the hedge fund industry, we find a high percentage of long / short equity managers who have delivered much higher gains 1982-2002 by avoiding the power of negative compounding. That is avoiding losses in down markets. The Liberty Ermitage Selz Fund, by way of example, has compounded at over 15% per annum from 1984 through 2002 delivering an impressive 950% appreciation with lower standard deviation than the market.
Both the charts illustrate why avoiding negative periods delivers superior risk adjusted returns: chart 1 clearly depicts the advantage of including the best 10 months when assessing investment performance. However chart 2 highlights the extraordinary benefits of excluding the worst 10 months.
A recent article from Barron’s delivers another blow to the argument for staying fully invested. Over the long term, gains from equity investment would be significantly higher if you invested from November to April and then exited to cash funds from May to October.
One of the most important aspects of hedge funds is their heterogeneity from a portfolio construction perspective. By this we mean the biggest failing of long-only funds is that they are all long. Also, most of these funds are highly correlated to one another. Thus building a diversified portfolio of long-only funds is often a contradiction in terms. When equity markets correct you find high correlations between all the long-only equity funds.
In the hedge fund world, because you have diverse styles / strategies, such as distressed, arbitrage, CTA and macro, you are able to put together portfolios where one can more effectively reduce risk and smooth returns through combining funds with positive returns, but with low correlations to each other – in the text-book world of portfolio theory this is the most optimal place to be.
Hedge (or really actively managed) funds, therefore, deserve much closer inspection.
Ron Mitchell is chief executive officer at Liberty Ermitage Group in Jersey