Do hedge funds have a place in client portfolios?

At the most basic level, there are typically only two ways to potentially generate a return on an investment in a financial instrument. First, one can passively collect a risk premium (beta). Second, one can actively extract money from other market participants (alpha).

Different asset classes are priced to have positive long-term estimated returns above cash. This is because investors who put money to work in such investments assume financial risk in doing so. They are thus compensated for taking on the risks of owning various investments by earning a return in excess of cash (ie a return in excess of the risk-free rate). And the level of risk inherent to an asset class is proportional to the return above cash – the risk premium – of that asset class: the higher the risk, the higher the return. This is evidenced by similar Sharpe ratios (the ratio of risk and returns) across the various asset classes despite varying levels of risk and return.

Betas tend to have low Sharpe ratios, and also tend to correlate to one another, in part because risk itself is the “key ingredient”. Finally, beta is tied to macroeconomic growth, and as long as economies continue to grow, investors can generally rely upon beta to help deliver positive long-term returns.

In beta investing, the investor accepts risks that are inherent to an asset class, and the compensation therefore is a risk premium. Since capturing beta is easy, it is also cheap and commoditised. The explosion of index funds and related products over the past decade allow an investor to “slice and dice” risk premia ever more finely for only a few basis points.

As the product of an individual manager’s active decisions, alpha is based on the assumption of unique risks – risks specific to a particular investment – rather than systematic ones. Since active decisions differ across managers, the risk of one alpha-generating investment has little correlation to either market betas or to the risk of another alpha-generating investment.

For example, an earnings shortfall due to a plant fire will have little correlation to other companies in the same industry to the equity market as a whole. Thus, alphas typically exhibit low correlation to one another. In addition, because each manager represents a unique alpha source, investors (theoretically) have access to far more alpha sources than beta sources. This implies that even on a standalone basis, combining multiple alpha sources can reduce risk much more dramatically than combining multiple beta sources.

Alpha, by definition, is uncorrelated with broad asset class returns. Adding alpha to traditional equity and fixed income-oriented portfolios, therefore, can potentially improve risk-adjusted performance if an investor can identify managers who generate positive alpha.

A key to successful hedge fund investing is the ability to identify and invest with “alpha-rich” managers. Beta is free and therefore acceptable. Alpha, though, is mandatory and thus in the modern world of hedge fund investing, an effective manager selection that targets its identification is paramount.

The competition for alpha amongst hedge funds has materially heated-up over the past decade, with a huge increase in the number of hedge funds since 2000. And all of these managers are competing for a finite pool of “best ideas”. Even with this, however, hedge fund allocations have generally benefitted investor portfolios. In 2008, the asset class as a whole defended capital effectively, with the average fund down less than half that of the MSCI World index.

Absolute returns are perhaps harder to come by in present-day hedge fund land. But to question the value that hedge funds add to client portfolios is to question the value of diversification, of capital protection, and of risk management itself.

Burkhard Varnholt, Bank Sarasin

No

Burkhard Varnholt, CIO and head of asset management products and sales, Bank Sarasin

Despite their neutral-sounding name, hedge funds tend to polarise investors. At Bank Sarasin we do not use any hedge funds – but other reputable asset managers do, and sometimes even promote their skills at constructing funds of hedge funds as a key selling proposition. Whom to believe? Unfortunately, there is no simple answer.

One perceived benefit of hedge funds is that they can better align their interests with investors. Originally, hedge funds were often set up as private partnerships or management contracts. They thus aligned the financial interests of talented portfolio managers with those of very few wealthy investors. This model continues to be the best – but it is not always sustainable, as successful managers often seek to outgrow their original investment mandate, which can then dilute or undermine performance.

Hedge funds are expensive, which is why they often attract the best portfolio managers. If, like me, you believe in active management, you would expect that the best managers prefer working where they receive higher compensation. Attracting talent with incentives is generally a good thing – provided that fees are linked to the risks and returns of the fund.

But there are concerns that they are too expensive. Just as 90 per cent of all car drivers consider their driving skills “above average”, a lot of fund managers suffer from overconfidence. A lack of benchmarks and sometimes limited transparency make it hard to single out those managers who are indeed as good as they claim. To make matters worse, even the genuinely superior managers often see their performance deteriorate after several good years because they allow their assets to grow beyond their scope of control. They become victims of their own success.

Cash, bonds and equities can match every desirable risk-return profile. As an old-fashioned investor, I prefer a skilful composition of these three elements to an expensive fund – which, frankly, must itself mix and match the same elements. In my view, these instruments are sufficient to express any investment view that an absolute-return investor might seek – and they are cheap in comparison.

Hedge funds are often illiquid. Cautious investors, like me, dislike illiquidity, especially when imposed as an investment rule rather than a necessity, as in private equity. Many hedge fund “exit gates” seem merely devices to retain investors for longer than the underlying strategy requires.

Hedge funds no longer have a technical advantage. Once mutual fund regulation allowed transparent use of financial derivatives, the most important advantage of hedge funds over mutual funds vanished. This leaves hedge funds with precious few structurally differentiating features. In today’s world, by far the most important differentiators between any two funds are the investment process and the manager.

Hedge funds can and do serve a useful role for investors who understand them well and monitor them regularly. The limited scalability of personal talent, however, makes the best hedge funds prone to performance deterioration. Their “Midas myth” is inevitably further weakened by the fact that they no longer possess any technical edge over those more old-fashioned investors who rely on skilful combinations of bonds, cash, equities, and possibly derivatives. Caveat emptor – let the buyer beware – should be the basic recommendation to every investor wishing to put money in hedge funds. Other investors should feel comforted that they can fare just as well (or indeed better) without using these less liquid, less transparent, less regulated funds.