The advantages and disadvantages of investing in hedge funds
Investing in hedge funds is one of the more polarising topics in the investment world. There are strongly-held views at each end of the spectrum, with little in-between, writes Craig Stanford, who highlights the potential benefits and addresses common concerns about investing in hedge funds.
The advocates of hedge fund investing paint a rosy picture without acknowledging the negative aspects, while the critics paint an opposing view without acknowledging the potential benefits.
As active hedge fund investors, we regularly have to address issues such as alignment of interests, higher fees, less liquidity, less transparency, and implementation.
However, we know that if we can manage these issues successfully, we’re able to take advantage of the associated benefits, which include improved portfolio risk/return characteristics, a reduction in the severity and frequency of losses, as well as access to new and otherwise unavailable return streams.
The accompanying graphs show a range of these benefits, by comparing various performance metrics for a typical portfolio of hedge funds to the median Australian growth superannuation fund over the last 20 years.
The portfolio of hedge funds is represented by the HFRI Fund of Fund Composite Index, hedged into Australian dollars.
This should be a fair representation of most investors’ experience, because it includes all fees and eliminates some of the bias in other indices.
The median Australian growth superannuation fund is taken from the Morningstar Australian Superannuation Survey – Multisector Growth universe, and draws on all funds in the survey which have a history dating back to 31 December 1992, a universe of 12 underlying funds.
Figure 1 shows that over this period, the return from the portfolio of hedge funds has been 1 per cent per annum higher (8.2 per cent compared to 7.2 per cent), with a volatility level 1 per cent lower than that of the median superfund (5.9 per cent compared to 7 per cent).
As Figure 1 shows, the median superfund also sustained losses 50 per cent greater during the recent financial crisis (-30.40 per cent compared to the portfolio of hedge funds’ -18.80 per cent).
As a result, the median superfund is still below its pre-crisis value, while the portfolio of hedge funds is well above its pre-crisis value (see Figure 2).
An initial issue to address is the poor general perception of hedge funds. The press frequently portrays hedge funds as speculators that are determined to destabilise markets, and media accounts of hedge funds losing money are common.
Our experience of investing in hedge funds is that these characterisations are inaccurate. This is not to deny that certain investors have experienced losses from investing in hedge funds.
However, we believe that in most cases these losses could have been avoided or contained with a well-structured due diligence and portfolio management process.
This highlights the importance of due diligence, which we regard as a critical part of the investment process in order to avoid investing in hedge funds where there may be catastrophic trading losses or fraud.
In the following paragraphs we detail some of the potential benefits of investing in hedge funds, before addressing some of the common concerns.
Potential benefits
Ability to reduce losses
One of the key benefits of investing in hedge funds is their ability to reduce losses during sharemarket sell-offs.
This is illustrated in Figure 3, which compares the performance of the median Australian growth superfund to a portfolio of hedge funds during the worst 10 months for the S&P/ASX200 Index over the 20 years to 31 December 2012.
{^image|(url)~/getmedia/a8bf901d-42a7-4e68-b211-6f8400a6d6e5/p19-f3-MM2609_019.aspx|(align)middle|(originalwidth)600|(mouseoverheight)358|(sizetourl)False|(behavior)hover|(originalheight)269|(hspace)5|(vspace)5|(mouseoverwidth)800^}
During these months, the portfolio of hedge funds lost an average of 3 per cent, although the loss for the median superfund was almost 50 per cent higher (-4.4 per cent), and the loss from the sharemarket was almost three times higher (-8.7 per cent).
This improvement in downside protection is an important part of improving a portfolio’s risk/return profile, and it’s clear that hedge funds have been successful at reducing losses during sharemarket selloffs.
Capital preservation
Hedge fund managers think about risk in terms of loss of capital, and actively manage risk to try to limit their losses.
A traditional fund manager, by contrast, tends to think about risk in terms of performance deviation from a benchmark, and will generally lose as much as the market does in difficult times.
Figure 4 shows why we think investing in hedge funds makes sense from a capital preservation perspective.
The graph shows the loss that each index experienced from 31 December 2006.
This was the worst example of hedge fund losses that we could find, and shows that the hedge fund portfolio lost around 19 per cent over a period when the median Australian growth superannuation fund lost over 30 per cent and the Australian sharemarket fell more than 45 per cent.
{^image|(url)~/getmedia/2137dbe4-7f95-45e0-9f31-c3c83c4e3b10/p19-f4-MM2609_019.aspx|(ext).jpg|(align)middle|(originalwidth)600|(mouseoverheight)365|(sizetourl)False|(behavior)hover|(originalheight)274|(hspace)5|(vspace)5|(mouseoverwidth)800^}
The graph also shows that the portfolio of hedge funds recovered from its initial losses by November 2010, although by December 2012 neither the superfunds nor the ASX had fully recovered their losses.
Diversification
By reducing exposure to general market movements and only targeting specific risks, a hedge fund can produce a return stream that has a low level of correlation with, and a lower level of downside volatility than, general risk assets like equities.
This has valuable benefits in portfolio construction, and can lead to a more consistent return profile in a diversified portfolio.
It pays to be careful when interpreting correlation statistics, because correlation is not the same as causation, but with this in mind, Figure 5 shows a measure of correlation using a statistic called R2. This is defined as the percentage of the movement in one index that can be explained by the movement in another index.
{^image|(url)~/getmedia/1c485b1a-52e3-435a-a77c-67324157b8c0/p19-f5-MM2609_019.aspx|(ext).jpg|(align)middle|(originalwidth)600|(mouseoverheight)342|(sizetourl)False|(behavior)hover|(originalheight)257|(hspace)5|(vspace)5|(mouseoverwidth)800^}
What Figure 5 shows is that approximately 90 per cent of the variation in the returns of the median growth superfund can be explained by movements in the Australian sharemarket, whereas this only explains 60 per cent of the variation in returns of the portfolio of hedge funds.
The graph shows that the portfolio of hedge funds displays a variable and consistently lower R2, while the typical growth superfund displays a consistently high R2 relative to the ASX.
The implication of this is that equities are a much stronger driver of returns for superfunds than is commonly appreciated, and that a portfolio of hedge funds can be a useful diversifier for a superannuation fund.
Potential hurdles
No discussion of hedge fund investing would be complete without an analysis of the potential hurdles. In the following paragraphs, we outline some of the common constraints and how we address them.
Fees
The high fees charged by hedge funds are often cited as a reason not to use them, to the point where the risk-adjusted returns after fees are not even considered.
Although we agree that fees matter, we think that this narrow view is a mistake. Because the goal is to improve risk-adjusted returns, we try to avoid looking at fees in isolation, and instead gauge the level of cost in relation to the expected value that the investment might add.
This leads us to conclude that there are a small number of hedge funds that are worth paying higher fees for, although we also recognise that the vast majority will not generate returns that justify their higher fees.
As an example, it’s worth considering the relationship between fees paid and value added by traditional investment managers.
Many studies have shown that equity managers as a group tend to underperform their benchmark on an after-fee basis, so that any value added tends to be offset by the investment manager’s fees. What this means for the investor is that the fees paid exceed the amount of value added.
Contrast this to a good hedge fund where the fees, although higher, only consume a portion of the value added, and the ratio of fees to value added is far more favourable for the investor.
We don’t think that paying higher fees is necessarily a bad idea if it results in a better investment outcome (higher net returns), and it makes little sense to make fee minimisation the focus of an investment program at the expense of a good investment outcome – what seems cheap initially could be very expensive in the long run.
Liquidity
There are two aspects to liquidity worth considering. The first is the liquidity offered through a fund’s normal redemption cycle.
The second and more problematic aspect is the ability or willingness of a fund to abide by its normal redemption terms during stress environments such as 2008.
We don’t think of the normal redemption terms as a constraint, since they’re known in advance and can generally be planned for, although we expect to earn a return premium for the lower level of liquidity.
In any case, the majority of investments in diversified portfolios offer daily liquidity, so having a small portion that offers monthly or quarterly liquidity should have little noticeable impact on total portfolio liquidity.
The second aspect, however, of not abiding by the normal redemption terms, is a concern – and was extremely poorly-handled by a number of hedge funds in 2008 when they used various methods to prevent clients from redeeming.
To manage this risk, we compare the redemption terms of each hedge fund to the liquidity of its underlying investments and ensure that these are appropriate.
We also consider the liquidity of each fund as well as the whole portfolio during both normal and stress environments, to ensure that this is kept at an appropriate level relative to the liquidity that we offer to our investors.
Transparency
Portfolio transparency can be considered on a number of levels, but the key for most investors is the need to understand how the fund’s portfolio is constructed, and what it contains.
Interestingly, despite some investors’ negative experiences, we have not found transparency to be an issue.
Most hedge fund managers we have encountered are comfortable discussing their portfolio and distributing useful summaries of the portfolio’s salient features on a regular basis. This information can also be cross-referenced with the fund’s audited accounts and administrator.
One touted solution to the transparency issue is the use of separately managed accounts (SMAs), although we believe that these come with both advantages and disadvantages.
Use of an SMA gives an investor greater security, because the investor owns the underlying assets directly and appoints an investment manager to manage the assets on their behalf.
Contrast this with a traditional co-mingled structure where the investor owns units, along with other investors, in a vehicle over which the investment manager has far greater control.
One of the key disadvantages we find with SMAs is that the better managers do not offer them, so the choice of funds will be curtailed and the performance outcome could be affected.
Conclusion
This article illustrates the rationale for allocating capital to a carefully chosen portfolio of hedge funds.
One of the key tenets of our investment philosophy is that generating and preserving wealth over time depends on the ability to compound wealth steadily and avoid large losses.
With this in mind, we think that it makes sense to allocate capital to hedge funds that are active risk managers with the ability to protect capital in negative market environments.
From a portfolio construction sense, it also helps if the hedge fund’s returns are driven by factors that are different to the drivers of return in most diversified portfolios – in particular, traditional equities and fixed income investments.
We think that investing in a carefully-chosen portfolio of hedge funds will result in more attractive risk-adjusted returns. We also think that an unconstrained approach which allows the broadest opportunity set to be considered is best.
Operational due diligence is paramount, and the return after fees is more important than the fees themselves. Hedge fund programs implemented on this basis have yielded superior results compared to the median Australian growth superannuation fund, and we believe should be a serious consideration for any diversified portfolio that aims to generate superior risk-adjusted returns over the long term.
Craig Stanford is head of hedge funds at Ibbotson.
AUTHOR
Staff Writer
Recommended for you
In this episode of Relative Return, host Maja Garaca Djurdjevic is joined by shadow treasurer Angus Taylor to discuss the current state of the financial advice sector, the economy, the housing affordability crisis and more.
In this episode of Relative Return, host Laura Dew speaks with Andrew Mitchell, director and senior portfolio manager at Ophir Asset Management, about why he loves working in fund management and the lessons he’s learnt in a decade of running a firm.
In this episode of Relative Return, host Laura Dew speaks with Blackwattle Investment Partners managing director and chief investment officer, Michael Skinner, about setting up an asset manager and what he looks for in an investment team.
In this special episode of Relative Return, Momentum Media’s Phil Tarrant and Jordan Coleman discuss the publishing house’s expansion into greater coverage of the wealth management space.
