Working around cycles
Whether it’s a bear market, bull market or neither, hedge funds earn their keep in any serious portfolio.
The idea has lodged itself in the heads of investment managers that equities are the superior long-term inflation hedge. This dovetails nicely with historical studies showing that stocks exhibit “superior” returns over the long term. But these alluring qualities mask a far more worrying attribute of the stock market: its long cycles of strength, weakness, and flatness. Indeed, entire generations of investment managers can grow up almost entirely in a bear market era (eg, 1970s) or a bull market era (eg, 1990s) and are accordingly indelibly influenced in their outlook. These long cycles make equities a very awkward instrument with which to hedge liabilities. Market treachery Shaken by the treachery of the equity markets, and unwilling to commit strategically to long-term bonds at current low interest rates, portfolio managers are turning to hedge funds. Many practitioners do not think hedge funds are a separate asset class at all, but rather an investment strategy. Hedge funds are risk-managed, strategically focused “portfolios” of actively (often publicly) traded instruments, which seek to identify and/or isolate anomalies in financial markets and exploit them for profit. These profit opportunities are identified by either mathematical modelling, such as global macro funds, or by intensive research into companies and special situations, eg, merger arbitrage, equity long/short and distressed securities funds. Most unwanted risks in the fund are hedged away, leaving the target risk to be isolated as the sole focus of the portfolio manager. The resulting “portfolio”, or hedge fund, has risk/reward attributes very unlike that of any of its constituent securities, or the markets for these securities. The result is fund performance largely independent of, and usually less volatile than, public securities markets. The role of hedge funds The prima facie argument of hedge funds is illustrated in the graph below, which compares major hedge fund indices over the past four years against public markets. The value of any discrete investment, however, can only properly be evaluated in the context of the portfolio in which it will reside. We analysed – for illustrative purposes only – what the effect on the average UK pension fund portfolio would have been in the last five years, if 25 per cent of this average fund had been invested in the hedge funds constituting the major hedge fund indices. We used as a proxy for an average hedge fund investment the average return and risk of three industry-wide indices: MAR, HFR, and CSFB/Tremont. Even average hedge fund performance, as reflected in these indices, would have markedly boosted returns and lowered portfolio risk for the average fund over the past five years. Ready for prime-time? Index performance notwithstanding, individual hedge fund returns can be quite idiosyncratic in the short run. Diversification across hedge funds is mandatory, and monitoring the funds’ performance is an ongoing, specialised and labour-intensive process. For these reasons, most institutions approach hedge funds by investing in one or more funds of hedge funds. Funds of funds provide the professional selection, third-party monitoring and reporting expertise that this type of investment requires. This service comes at a price, but the rational investor chooses to focus on net returns and risk. Hedge funds have been with us since the late 1940s, and have grown over the decades from obscure investment vehicles to multi-billion dollar companies. For those willing to make – and pay for – the effort to manage actively a portfolio of mature hedge funds, these assets can serve as a stabilising source of return while lowering portfolio risk. This would be one concrete step towards diversification so sorely lacking in the past. Kenneth Ward-Smith, managing director, Auda. Formed in 1989 to manage hedge fund and private equity investments of the Harald Quandt family, Auda now manages $2bn for institutions and very high net worth individuals.
