Hedge fund investing for institutions to become mainstream

by Dr. Ros Altmann

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UK institutions are finally waking up to the tremendous potential of hedge funds. Some major pension funds (BT, West Midlands Local Authority and Railways) have decided to allocate hundreds of millions of pounds to hedge funds. In fact, UK institutions have been rather slow in committing money to this area. US and Continental European investors have moved more quickly and benefited from the superior risk-adjusted returns offered by alternative assets in the past few years. UK consultants have also been relatively cautious in recommending consideration of hedge funds and have only recently invested significant amounts of resource in understanding the benefits of this type of investment, as an additional form of diversification for traditional equity/bond portfolios.

Hedge funds are often said to be ‘too risky’ for most investors, but I believe such fears are overdone. Hedge fund investments, in my view, should be carefully considered as a core part of any long term investment portfolio. I believe absolute return investing is likely to become mainstream one day, to rival, or even replace, traditional index-based 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 fund of hedge funds should provide this diversification and also assist with the extensive due diligence that would normally be required, to identify top managers and the best combination of both managers and strategies. For smaller institutions, using a fund of hedge funds is probably the only way to achieve diversification, since the minimum holdings in individual hedge funds tend to be high. However, for larger funds, it would be possible to use in-house analysis to try to put together a portfolio of hedge funds.

In order to do this, significant investment is needed, to understand how hedge funds work and carry out detailed due diligence checks on managers. 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. It is, therefore, vital that institutions recognise the challenges they face in hedge fund investments and devote the necessary resources to this area. The rewards can be substantial, but many newer managers may fail and analysing hedge funds is much more difficult than analysing long-only management.

A hedge fund is a product structure, rather than an investment strategy and the structure is normally designed to deliver absolute returns, lowly correlated with returns on traditional assets, or not correlated at all. There is an enormous range of strategies used by hedge fund managers, but most 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. Institutions, such as pension funds which have large deficits to try to make up, are becoming much less tolerant of 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. This is valuable to institutions which are struggling to pay out liabilities over time and are very sensitive to achieving more reliable returns. The lack of correlation between hedge funds and traditional assets, means that institutional portfolios will benefit from diversifying into hedge funds investments. There should be an improvement in risk-adjusted returns and several research papers have suggested institutions should commit at least 10-20% to hedge funds.

It is important to understand, however, that hedge funds will not always outperform traditional asset returns. They are designed to perform more consistently in absolute terms. Since they aim to generate returns that are independent of, or lowly correlated with traditional assets, 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.

Of course, hedge funds are 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.

Unfortunately, investors considering a first exposure to 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 is strong. To build up a diversified hedge fund portfolio would require several million dollars, which may be more than some institutions want to commit initially. But with a fund of funds, investors 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, 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. 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.


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