Harry Kat, professor of risk management at Cass Business School in London doesn’t think so. In fact, he advises investors to steer clear of hedge funds altogether, claiming that with returns “routinely around 6 per cent to 7 per cent,” these investments are “basically the same as glorified savings accounts”. If fund managers are taken out of the picture, he adds, returns can be boosted by 2 per cent or 3 per cent.
Professor Kat advocates instead the use of synthetic funds which deploy purely mechanical futures trading strategies, thereby avoiding the need for expensive asset managers.
He argues that since they only trade in the most liquid futures markets, synthetic funds also avoid the need for extensive due diligence, liquidity, capacity, transparency and style drift problems. And the potential gains? In some cases, a very respectable 10 per cent average annual return, according to Professor Kat. He claims that a test involving almost 2500 funds of hedge funds, shows that over the past 15 years, synthetic funds would have outperformed funds of hedge funds 82 per cent of the time.
Wait a minute, though. While funds of hedge funds might have failed to live up to institutional investor expectations, the same cannot be said of all single hedge fund strategies.
For instance, the yield on the HFRI [Hedge Fund Research Indices] Fund of Funds Composite Index was 8.17 per cent for the year to end-November 2006 . This index significantly underperformed both the S&P 500 and the FTSE 100 over a one and three-year period to end-November. However, many investors who chose instead to build a portfolio of single strategy hedge funds were rewarded with double-digit growth. Emerging markets funds led the way with the HFRI Eastern Europe/CIS Index yielding 30.35 per cent for the year to November. The performance of the HFRI Asia Index (22.34 per cent) Latin America Index (15.22 per cent) and Emerging Markets Global Index (15.30 per cent) further vindicated the single strategy approach. Other hedge fund strategies which performed well in 2006 included event driven, distressed securities and convertible bonds.
But strategies such as equity long/short
and equity market neutral posted what many investors regarded as disappointing single-
digit gains.
Despite the mixed bag of returns, surveys in 2006 showed that subscriptions to hedge funds are forecast to grow. A recent study by the Bank of New York found that global institutional demand for hedge funds will increase from $360bn currently to more than $1000bn by 2010. By then, said the report, nearly 25 per cent of institutions will be investing in hedge funds.
And Greenwich Associates said that 35 per cent of continental European institutions identified themselves as hedge fund investors in 2006, while another 10 per cent said they have plans to begin investing in hedge funds in 2007.
At the same time, Greenwich revealed that at 2 per cent of total assets, actual allocations to hedge funds have shown no increase on 2005.
So confident apparently are asset managers that interest in hedge funds will translate into hard mandates, that they are focusing on launching more alternative investment funds in the future. According to a recent report by Investment Solutions, a provider of multi-manager investment portfolios, hedge funds will account for 18 per cent of new product launches over the next three years, up from 13 per cent of new products launched in the last three years. The rise in alternative investment products will come, said the report, at the expense of high alpha/unconstrained equity products. Almost 40 per cent of managers indicated their intention to roll out more alternative investment products.
Not surprisingly, Investment Solutions recommends the use of multi-managers to lessen the challenge of choosing the right asset manager and the right product.
But although multi-manager funds and funds of funds remain the preferred choice of first-time investors, performance figures suggest that, if possible, they should instead build a diversified portfolio of single strategies at lower cost.
While this course of action will not be economically viable for the majority of small-to-medium-sized pension funds, large, well-resourced schemes should seriously consider the single strategy route, perhaps in conjunction with synthetic funds.
Finally, which strategies should the investor select in 2007? According to fund of hedge funds manager, Forsyth Partners, convertible arbitrage is a good bet on the back of a buoyant equity market, which will aid new issuance. Continued M&A activity should support ideas for special situations managers, while in high yield, corporate spreads are expected to widen.
Henry Smith, editor
henry.smith@ft.com
