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Financial Times ‘Personal View’ Column on Hedge Fund Investment by Dr. Ros Altmann (All material on this page is subject to copyright and must not be reproduced without the author's permission.) UK institutions are finally waking up to the tremendous potential of hedge funds. Two major pension funds (BT and Railways) have decided to allocate hundreds of millions of pounds to hedge funds. Many private investors are wondering whether to follow. Hedge funds are often said to be ‘too risky’ for most investors, but I believe such fears are overdone. Hedge fund investments should be carefully considered as a core part of investment portfolios and may become mainstream investments one day, potentially to rival traditional active management as the actively managed investment of choice. Hedge funds are often misunderstood. They are not necessarily more risky than traditional investments, but they entail different risks. It is important for investors to be aware of these risks and how to control them. Hedge funds are a much more modern method of managing money, harnessing the latest developments in financial techniques and investment banking. This makes them more complex than traditional investments and more heavily reliant on the skills of the individual managers, rather than on general market movements. Specific manager risk is, therefore, very high and it is essential to invest in a diversified range of managers and strategies, to mitigate these risks. A hedge fund is a product structure, rather than an investment strategy and the structure is more naturally aligned to the investment aims of private investors. For example, hedge funds aim to achieve positive returns, rather than just outperforming a market. The concept of ‘risk’ for hedge funds relates more to ‘loss of capital’ than any ‘tracking error’ against an index. This is much more aligned with private investors’ idea of risk. They do not like losing money and are not usually happy being told their manager has performed very will because the portfolio ‘only’ lost 20% when the market fell by 25%. Hedge funds use sophisticated risk management techniques, which add to the complexity of their operations, but can control downside risks if done properly. Risk of capital loss is an essential feature of hedge fund investing, which investors must understand. Hedge fund managers aim to capitalise on market inefficiencies and profit from identifying both undervalued and overvalued securities. This means that they will go ‘short’ of a security they believe is overvalued (sell stock they don’t own, or use futures or options) which entails particular risks. If a short position goes wrong, so that the security price rises rather than falls, the hedge fund position will show a loss. If the security price keeps rising, the loss will grow and become an ever larger part of the portfolio. It is, therefore, vital that hedge funds have stop losses and risk disciplines in place to manage the short positions properly. With long only management, if a long position goes wrong, the value of the investment falls and becomes an ever smaller part of the portfolio, which is much less damaging. This is why, being a successful hedge fund manager requires different skills from traditional investment. Being a top performing long only manager, does not ensure success in hedge fund investing. Trading, timing and risk control are much more important in the hedge fund world. Hedge funds will not always outperform traditional asset returns. They aim to generate returns that are independent of, or lowly correlated with traditional assets. This means they should do better than the market in a downturn, but underperform in a strong bull market. Over the long term, however, they should outperform. Potential investors should understand that hedge funds are, of course, risky, but so are almost all other investments. The risk of losing money is a fact of ‘investment life’. Many investors just hold equities for the long term and ride out market falls. But, if the market falls by 50%, it has to double from there to get back to where it started. Successful hedge funds will not lose the 50% in a downturn and will then need to rise by much less than the market to deliver long-term outperformance. Hedge funds are lightly regulated, so investors have less comfort that the managers are operating in any ‘approved’ manner. But regulation can only provide limited protection. If markets go down, investors in regulated products usually still lose money. Investing in hedge funds should not make a portfolio more risky. In fact, including hedge funds can actually reduce portfolio risk and improve the risk-return profile, due to the low correlation levels. Unfortunately, investors considering a first foray into hedge funds face significant hurdles. The best funds often require large minimum investments ($1 million or so) and dealing may only be quarterly or less frequently. High specific fund risk makes it essential to carry out detailed due diligence and continuously monitor managers, to ensure their operations and risk controls are well-structured. In light of these problems, the case for using a well-proven fund of hedge funds seems overwhelming. Anyway, without a fund of funds, most private investors could not access hedge funds at all. To build up a diversified hedge fund portfolio would require several million dollars. But with a fund of funds, investors with more modest means can participate in a broad range of managers and strategies (some of which are not available to new investors at all). Choosing an experienced fund of funds manager provides access to significant expertise and letting the experienced fund of funds manager conduct detailed due diligence checks and monitor managers makes great sense. However, beware of newly-formed multi-manager funds without proven experience in this area. To
sum up, markets will always be inefficient, so hedge funds should
continue to profit from identifying undervalued and overvalued investment
opportunities. Investors must ensure their chosen managers are skilled
in both investment selection and risk control. Both elements are
vital to success in hedge fund investing, but investors would struggle
to identify these skills on their own. For most new investors, using
a good fund of hedge funds manager is likely to be the key to success
in this complex, challenging, yet compelling environment. |
