In times of financial uncertainty investors instinctively try to take refuge in safe financial solutions. As global markets increasingly tend to rise and fall in unison, investors seek new investment opportunities that provide the benefits of diversification without foregoing attractive returns. This search for alternatives to traditional investment vehicles has led to the phenomenal rise of Hedge Funds.
Over the last years, spectacular successes such as the multi-billion dollar Quantum Fund managed by George Soros, and even more spectacular failures such as Long Term Capital Management (LTCM), have brought Hedge Funds to the attention of the general public. Despite the ups and downs in the industry, Hedge Funds have continuously claimed to have discovered the holy grail of investing: the achievement of high returns with low risk.
What are Hedge Funds in reality?
Are they highly leveraged structures aiming to create superior returns? Or are they simply a new investment class with reduced risk due to their minimal correlation to other investments? The answer is neither and a little of both.
Originally a group of unconstrained and generally renegade stock pickers, Hedge Funds have evolved to include a broad range of investment strategies. Unlike Mutual Funds, Hedge Funds have broad flexibility in the types of securities they hold and the types of positions they take. Hedge Funds can invest in international and domestic equities and debt as well as the entire array of traded derivatives. They may take undiversified positions, sell short or leverage the portfolio. The term Hedge Funds includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. However, one common element of Hedge Funds is the disciplined use of investment and risk management skills to seek positive returns regardless of market conditions. While the more spectacular successes and failures of Hedge Funds have been achieved by speculative and highly leveraged Hedge Funds strategies, it is in fact the aim of a large majority of fund managers to manage and limit primarily one thing: Risk.
Today, the capital base of the hedge fund industry exceeds USD 400bn and includes more than 1500 investment advisors managing over 4000 different funds.
What are the typical characteristics of Hedge Fund investments and what are the consequences thereof?
First of all, the generally higher average risk-adjusted performance of Hedge Fund managers as compared to traditional managers suggest that a larger percentage of wealth should be invested in Hedge Funds than previously assumed.
Secondly, Hedge Funds are comparable to traditional active investment in as far as structural, administrative and compliance risk is concerned. As a result, the selection process of Hedge Fund managers should be as thorough as in the case of traditional fund managers.
Thirdly, the larger dispersion of performance results as compared to large cap fund managers creates the possibility of potentially higher returns but bares the potential for greater loss. This necessitates a careful selection and diversification between Hedge Fund managers.
Fourthly, the fact that a favourable diversification can be achieved with far fewer investments across the universe of Hedge Fund managers than among traditional managers indicates that the active and professional aggregation of Hedge Fund managers leads to superior investment results.
Lastly, the universe of Hedge Fund managers exhibits considerably less risk than traditional active managers due to their low correlation to common index benchmarks. Investments in Hedge Funds therefore provide exactly what the name suggests: a hedge against adverse effects to the overall portfolio.
What do Hedge Funds do in reality?
In order to achieve the goal of risk reduction, Hedge Funds employ hedging and risk management techniques of various levels of sophistication and complexity. In the words of a hedge fund specialist, Hedge Funds aim to "make investments that display a low or even negative contribution to investors' overall portfolio risk while offering relatively attractive returns versus cash". For the common investor this means that Hedge Funds seek to provide attractive diversification that contains or even reduces the overall risk of the portfolio while positively enhancing the return. Here, as always, the underlying investment portfolio determines the extent to which risk reduction can be achieved and also defines the choice of appropriate Hedge Funds strategies.
Are all Hedge Funds acceptable investments for private investors?
The answer is clearly no. Anecdotal evidence suggests that companies are as likely to go bankrupt as hedge funds are likely to lose their entire value. This means that Hedge Funds overall have the same default risk as common equity investments. Consequently, the private investor should carefully, but not timidly define the allowable risk of any specific investment. Caution in selecting equity as well as Hedge Fund investments should therefore always be the principle of choice.
Which Hedge Funds should be selected as attractive and stable investments?
Selecting Hedge Fund managers on the basis of strong past performance alone is fallacious. The commonly accepted truism that past performance is no guarantee for future performance is particularly true in the Hedge Fund industry. Characterized by a relatively high attrition rate of funds, many successful individual Hedge Fund managers tend to close their funds or leave the industry altogether, thus bequeathing a once glamorous fund to less experienced successors. The ensuing discontinuity in management expertise often dooms the long-term success of such a fund. It is therefore essential to monitor the managers of Hedge Funds vigilantly and to take the immediate actions to secure the integrity of the investment.
Recent performance comparisons, compiled by independent research institutes, suggest that the compound annual return of hedge fund managers is higher and less risky than a comparable universe of traditional asset managers. But, despite the importance of long-term performance, there exists a distinct "hot-hands" effect of new funds often making newly launched funds by a reputable investment manager an attractive investment. As there appears to be little connection between amount of assets under management and investment success, investments in Hedge Funds can be made disregarding the size of a respective fund. Finally, the trade-off between the specialization and exclusivity of small Hedge Funds and the diversification and liquidity of large Hedge Funds often boils down to simple investment skill questions.
For the normal investor the question remains of how to participate in a diversified Hedge Fund product?
As mentioned, the Hedge Fund industry is characterized by a high attrition rate and the investment strategies tend to be more complex as compared to mutual funds. Accordingly, the assessment of the true characteristics and their appropriateness for normal investors requires an extensive know-how and is therefore best left to specialized financial advisors. Today, many financial institutions offer attractive Funds of Hedge Funds products which essentially are bundled selections of different Hedge Fund managers with various investment styles. Through such multi-manager funds, the individual investor can gain access to the benefits of Hedge Funds without committing a disproportional amount of capital.
Conclusion
Hedge Funds are an alternative to traditional investments because they provide diversification of risk in a world that has become increasingly interlinked and correlated. In addition, the general performance target to achieve positive returns, makes Hedge Funds an investment uniquely in-tune with the needs and expectations of Private Investors. A significantly improved overall risk of the respective portfolios of Private Investors will be achieved due to the innate nature of Hedge Funds: the ability to generate highly attractive risk-adjusted returns in varying market environments.
Despite their bravura image, most Hedge Funds are generally low risk and absolute return oriented, making them complementary to traditional investment styles. By achieving equity type of returns with bond-like risks, Hedge Funds often achieve a very attractive risk/return trade-off. Hedge Funds are, if used carefully and professionally, an important addition to the total portfolio. In the context of total wealth management, Hedge Funds should have a rightful and permanent place in the overall portfolio of the Private Investor.
AndrT Ruppli, CIO Dresdner Private Banking International.
