When I last wrote on hedge funds an entire section of a subsequent edition was devoted to responses explaining the flaws in my argument and character. Having bomb-proofed my house I will again venture onto this topic.
Centrestone has a hedge fund on its recommended list (two if Platinum is called a hedge fund), but no hedge fund-of-funds (FoF). Our attitude is neither blanket condemnation nor acceptance, but cautious discernment. This contrasts with the unbridled enthusiasm reflected in pronouncements that portfolios should devote 10 per cent to the area.
It is claimed that hedge funds are sound diversifiers, consistently able to produce good returns.
The range of strategies loosely grouped under the ‘hedge fund’ label is so broad that any generalisation is dangerous — including that they are absolute return — but I will focus most on this approach.
Is high return with low risk ‘nirvana’ possible?
Let’s talk about factors which work against hedge funds.
Fees: A typical fee structure is 1 per cent per annum plus 20 per cent of profits totalling, say, 3 per cent. A FoF may increase this by, say, 50 per cent, to around 4.5 per cent — roughly four to five times that of a typical wholesale fund. No conventional managed funds justify these fees.
Tax: Hedge funds generally offer few tax advantages such as the capital gain discount, imputation credits, and so on. They produce mainly taxable income or non-discounted capital gains.
Transparency: Most conventional fund managers willingly explain their strategies and, periodically, full details of their underlying portfolios are available. By contrast, most hedge funds are far from transparent (sometimes for sound market intelligence reasons). Hence, normal research scrutiny is rarely possible.
Some hedge fund assets are illiquid and difficult to price, requiring funds to ‘self-mark’ asset values. This allows the possibility of ‘marketing supportive accounting’ to artificially smooth reported returns.
Gearing: Most, but not all hedge funds, involve gearing, from mild to extreme, which inherently increases risk. Some gear into large positions in illiquid markets.
Not market correlated: Over the long-term, the average share, property or interest-bearing investment will produce a profit, because their long-term trend is up. An investor with no skill other than patience can reasonably expect a profit. ‘Market-neutral’ funds forsake this source of long-term profit.
The average conventional manager has difficulty in beating a market. The bulk of their return is produced by the ‘upward bias’ of the market. Absolute return funds must do what most others can’t — add value using their own skills.
Hence, manager selection is especially critical — any old hedge fund won’t do.
Market neutrality means a fund might make a profit whether a market rises or falls. Equally, it may make a loss. The single worst performing fund on Morningstar’s database in 2003 was the Challenger Long Short Fund. This lost more than 20 per cent in a year in which the market rose by 15.9 per cent. Indeed, not correlated but not really low risk/high return.
‘Flavour of the month’: Experience suggests that investments become fashionable at the wrong time — take technology stocks for example. Tremont claims last year’s inflows doubled the previous record, yet many suffer capacity constraints. Are we in an ‘alternative’ bubble?
Hedge funds seem over-promoted with occasional claims about consistently making 10 per cent plus per annum after fees. In a 2 to 3 per cent inflation environment, this is a 7 to 8 per cent real return.
Australian shares, during the 20th century, produced a real 8 per cent per annum return, with considerable volatility. Can hedge funds really match the highest return asset class with low volatility?
Summary: The jaundiced view is that hedge funds are an expensive, tax-inefficient, non-transparent, illiquid, geared, flavour-of-the-month investment, which can lose money all the time even in rising markets and which rely particularly on the skills of the selected manager.
I acknowledge (critics please note) that this summary is undeniably over-generalised and excessively negative.
However, it should encourage more caution than many currently exhibit.
In reply, promoters point to a strong track record to prove hedge funds deliver.
The harshest sceptic can’t help but be impressed by hedge funds’ reported past performance.
Graph 1 shows Hedge Fund Research Index (HFRI) returns for five different strategies over a decade (a limited number have been included to make the graph comprehensible).
The lines in the graph diverge widely, confirming that generalisations are dangerous.
Yet each strategy has made money from 16.1 per cent per annum to 4.9 per cent per annum.
If the worst return is 4.9 per cent per annum, surely this overwhelms all the reservations listed above.
However, a little further enquiry may be useful.
Graph 2 compares two styles reported by researchers who use different methodologies and samples. Very different results are reported. Why is this?
Equity indices can utilise methods that ensure they are representative of a broad spectrum of securities. Hedge fund indices are less able to.
There is a ‘survivor bias’ in hedge fund indices, which only report funds that are still operating. When a fund is terminated, its historical record is removed from the sample. Evidence demonstrates that poorer performing funds are more likely to close (see breakout, Attrition rate).
Researchers disagree about how much this exaggerates returns, most estimates being in the 2 to 4 per cent per annum range for the hedge fund universe (0 to 10 per cent for individual strategies).
Some, but not all, indices also carry instant history bias. Many funds will start and some will fail.
Others will do well enough to seek public capital and begin to report their returns publicly. Only this unrepresentatively successful sample enters the statistics.
In some strategies, the source of return is not market neutral value add but increased risk. Distressed securities may earn above normal yields because they invest in junk bonds.
Likewise, gearing is a risk/return accelerator. A geared junk bond or geared long bias long/ short fund may offer a high return — but they are not diversifiers.
These factors make an assessment of the extent to which absolute return funds do add value and diversify risk difficult.
A practical test of theory vs reality is the performance of local FoFs. Over several years, many have beaten cash, thus diversifying away from equities while delivering acceptable returns.
Most FoFs are fully currency hedged against the $US. This will have contributed around 3 to 4 per cent, that is, a material proportion of recent years’ returns.
This yield premium will continue while the American/Australian cash rate spread endures (this applies equally to any hedged fund — bonds, equities, and so on).
Net of this yield premium, most Morningstar reporting FoFs appear not to have matched cash over two or three years.
This area requires rigorous analysis. Our research does not entirely dismiss the concept. We believe one or two strategies are clearly robust. The distinction between long bias long/short funds and not-fully-invested share funds is also grey.
However, we lack conviction about an otherwise beguiling track record. We don’t believe high return with low risk is possible (and we recommend a medium risk/return fund). We can’t understand how a large proportion of funds can beat markets, despite prohibitive fees, when most other investment professionals can’t. And we don’t do what we can’t understand.
We reject the ‘70 per cent equity always’ paradigm. We don’t use closet indexers. We accept the need to diversify away from shares, but this is not difficult: hybrids, property, cash and bonds all diversify.
We are not persuaded that all portfolios must have 10 per cent or higher hedge fund exposure, nor that this should be obtained through the fund-of-funds approach.
Presumably, some FoFs will do well — but it is difficult to know who can sustain this.
Robert Keavney is chief executive of Centrestone Wealth Advisory .
