FTfm article on recent hedge fund performance
by Dr. Ros Altmann
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Many commentators have jumped to the conclusion that recent lacklustre performance marks the end of a hedge fund ‘bubble’ and proves it is too late to chase hedge funds. I do not agree. There are, of course, valid concerns about the dangers of leverage, high fee levels and the uncertainties of momentum-style investing in directionless markets. However, these potential problems are probably less of a worry than the issues associated with the fact that so many new managers are trying to enter the hedge fund space. This is still a relatively immature industry, with significant longer-term growth potential. The sudden surge of new start-ups, as managers are attracted to the higher-fee environment, is bound to lead to some dilution of returns in the short-term, with new managers being more likely to fail, but this just means judicious choice of managers is crucial.
Managing hedge funds is very different from long-only management. The search for alpha is not straightforward. Being a successful traditional fund manager, even one who has outperformed indices for years, does not guarantee success in hedge fund management. Hedge fund added value comes from both long and short positions. Managing the short side is at least as important as managing the long side, but takes different skills. Managing longs requires fundamental flair, in-depth analysis and/or sophisticated valuation models, while successful shorting relies more heavily on trading skills, stop-loss controls, good systems and disciplined implementation. When a long position goes wrong, it becomes an ever smaller part of the portfolio, but if a short position goes wrong, the losses increase. If leverage is applied, risks are magnified further, which could be particularly dangerous for inexperienced hedge fund managers. Robust risk control is crucial.
Market conditions this year have been unfavourable for hedge funds, but experienced managers have seen such times before. Momentum style investing in directionless markets will generate poor returns, but markets do not stay directionless for ever. Low levels of merger activity (which are showing signs of picking up now) have diluted potential returns for merger arbitrage, with too many managers chasing the few deals that have emerged. Convertible arbitrage has been hit by low issuance and narrowing credit spreads. Other strategies, such as long-short and global macro, have suffered from low market volatility.
In these trendless markets over the past few months, many of the longer-established hedge fund managers have reduced risk levels, and focussed on capital preservation, rather than trying to leverage up. The best hedge fund managers will always consider the potential returns that can be generated for each unit of risk and, in difficult market environments, they will be more likely to wait, rather than feeling under pressure to trade. Those with less experience might try to chase returns aggressively and, for example, if interest rates rise, as has happened lately, highly leveraged funds could be badly squeezed, leading to failures. This is a potential danger for unwary investors.
Of course, it is important to remember the basic rationale for investing in hedge funds. Investors should not approach these investments with short-term time horizons and, of course, the returns come from capital growth, not income. Particularly from an institutional perspective, a major reason to invest in hedge funds is to capture the benefit of absolute return investing (i.e. downside protection) and the low correlation with other assets, which should deliver superior returns and efficiency gains to long-term portfolios. The successful delivery of absolute returns is suggested by fact that during the market cycles of the last 5 years, from August 1999 to August 2004, the maximum peak to trough capital loss for funds of hedge funds (i.e. maximum drawdown) was -4.9%, compared with falls exceeding -40% for global equities and FTSE100 and -7% for global bonds. Returns for all asset classes have been depressed in recent years, but the potential enhancement of risk/return profiles suggests good hedge funds should be a valuable addition to portfolios.
Fee levels are another source of criticism. High costs and fees are part of the equation for adding alpha, however, performance net of fees is the most important yardstick and investors must decide if the added value is worth paying for. Having said this, though, there are some indications of a decline in institutional hedge fund fee levels with 1% annual charge plus 20% performance fee, replacing the previously typical 2% plus 20%. Increased emphasis on performance fees, with a reduction in the flat fee, would continue to ensure that managers’ and clients’ interests are aligned.
I expect hedge funds to continue to develop as a major institutional asset class in future. The initial phase, using funds of hedge funds to access a broad range of strategies, is likely to mature into one where institutions will want specialist hedge fund exposures. For example, using market-neutral to add diversification benefits and long-short equity as part of the purely active satellite component of a fund’s equity allocation. Hedge funds combine the advantages of focussing on downside risk control and purer harnessing of investment skill, with modern technology and financial instruments. Relative to pure stock pickers, or long only specialists, emphasis on absolute returns and low correlations should improve the efficiency of long-term portfolios.
Naturally, certain market environments will lead to periods of poorer returns, but over the medium term, hedge fund techniques should continue to provide attractive return potential. As long as markets remain inefficient – and I believe they always will – the opportunities for hedge funds to add value will remain.