There has been no shortage of discussion surrounding alpha-related products in pension fund management – whether in the form of active management in traditional asset classes or other products such as absolute return funds, or hedge funds.
Hedge funds have been positioned as an attractive asset class, offering high returns with low volatility and a low correlation with other assets. However, these characteristics are somewhat illusory.
Hedge fund indices show returns have been high. However, these indices represent the performance history of a limited number of hedge funds. Due to the way the index is constructed and how the return history is calculated, many less successful hedge funds were excluded. Therefore the index return will generally be higher than the true average return achieved. An investor using the historic returns of these indices is probably being optimistic.
Added difficulties include identifying where such products fit within the overall investment strategy, how much to allocate and how to compare funds. Consequently, investment has been undertaken in an arbitrary manner and misunderstanding persists.
Hedge funds are not a true asset class in that characteristics of the average or index return may be different from those expected of any one fund. Equities, bonds and other traditional asset classes have an economic rationale for giving positive returns. Hedge funds have no economic theory underlying their positive performance; the returns are achieved by the managers’ ability to exploit other investors in the zero sum game of the markets.
Many institutional investors have rejected the use of hedge funds discarding them as too risky, but several North American foundations have enjoyed success with hedge funds. Naturally, there are risks in investing in hedge funds, but some of these canbe mitigated.
Skilful hedge fund managers can provide high returns. The challenge for investors is identifying them. Many hedge fund strategies differ from those used by traditional managers and a degree of expertise is required. Investors often lack this expertise and are unable to make judgements between different managers, nor spot when their chosen manager is drifting from the agreed investment approach.
This is exacerbated by inadequate transparency making it difficult for investors to understand the investment process. Unless an investor is happy to invest based only on confidence in a specific manager, gaining expertise or employing an independent adviser is vital.
One differentiating characteristic of hedge funds is the use of leverage. Leverage – or gearing – magnifies the extent of profits or losses by borrowing assets. Managers use leverage when they see more opportunities in the market or have more conviction in their ideas. There are good reasons to reject a manager who uses leverage inappropriately or erratically.
Investors should view leverage risk in the context of their whole portfolio and not in isolation. It is straightforward to reduce the leverage of an investment and is erroneous to reject a hedge fund on the grounds of leverage alone. In fact, the limited liability structure of many hedge funds could offer some benefits to a highly leveraged approach.
Investors are also nervous of hedge fund regulation. Many hedge funds are set-up in offshore regulatory environments which are perceived as less demanding than onshore regimes. However, regulatory risk is declining as investors become familiar with the offshore regulations, and changes in UK regulation mean almost all types of hedge fund can now be authorised by the Financial Services Authority.
Some high profile hedge fund melt-downs, have given the asset class a reputation as being prone to fraud. It is certainly true that some fund reporting structures have not been as strict as they could be, however, looking for some simple operational risk controls – such as an effective third party to value the assets – should mitigate much of this risk. Investors can also limit fraud by ensuring the fund has effective risk controls for those authorised to instruct brokers and other third parties. Investors should also assess hedge funds on the level of fees, minimum lock-up periods and limited ability to withdraw funds.
Investing in a hedge fund for absolute returns appears to present some extra risks for an investor, but most of these can be managed. The largest risk to investors will be the lack of expertise and the inability to spot when or why things are going wrong until performance declines.
For investors still uncomfortable with hedge funds, there are other ways to achieve absolute returns. Numerous equity products are run traditionally, with no short positions and no leverage, whose objective is to achieve positive returns. Typically these products will not use the index as a benchmark and will not take the weight of a stock in an index into account.
This approach frees the manager to pick its best ideas and not to hold stocks merely because they form a large part of the index. This type of product does not have the flexibility of a hedge fund and an absolute return objective may have to take a longer-term approach to be realistic.
The investor looking for absolute returns has a wide range of fund management products to choose from and institutional investors should not reject any of these options without first gaining a full understanding of the risks and how they can be managed.
Matt Gibson, investment consultant, Hewitt Bacon & Woodrow
