While they are still viewed with caution, Rebecca Jones looks at whether hedge funds could offer an attractive alternative for investors in a climate of lower returns.
Mike Horseman, director, Cockburn Lucas
Hedge funds can be an incredibly useful investment tool when used correctly, but that comes with a lot of warnings and requires a huge amount of expertise to get the call right. Unless you understand what goes on in that hedge fund – what it does, the type of funds it uses and where its jurisdiction is – buyers beware.
They can be expensive: certainly, a lot of the old hedge funds were always 2 plus 20 [2% annual management fee plus 20% performance fee]. However, I’m sure hedge fund managers would argue they are using both pretty unique strategies and people, and you have to pay for that.
We would not just use hedge funds for high risk investors but as part of a portfolio strategy. For example, if we were going to invest for a client on a defensive basis, we might want to cap our equity weighting at 35% to 40% and, with the rest of the assets, probably buy fixed income, cash, property and alternative investments, such as hedge funds.
Are hedge funds a good bet for 2014?
We could even put 20% into hedge funds because we are going to dampen volatility, reduce the downside risk and go towards more of an absolute return than a relative return. With that in mind, they are not just for high risk investors; they can be very suitable for lower risk investors too.
It is also worth remembering that one of the biggest selling investment products out there – Standard Life Investemnts’ GARS – is essentially a hedge fund. It makes bets on directional markets, currencies, long-short positions, arbitrage and so on. It may be a vanilla hedge fund, in that it has no gearing, but, to all extent and purposes, it is one.
Scott Gallacher, director, Rowley Turton
Hedge funds are usually very expensive compared to traditional managed funds and their history is littered with spectacular failures. From an adviser’s perspective, you are never exactly sure what you are getting.
Generally, they rely on gearing, so are arguably much higher risk than traditional alternatives. For most clients, I would argue they do not offer an appropriate risk-reward trade-off. Granted, a lot of clients need to take some risk for a better return but, for most, that stops some way short of hedge funds.
In the past five years, all assets, in simple terms, have been going up in price. It is not surprising, therefore, that we have not seen any spectacular hedge fund collapses. I suspect that, if asset prices were to move in the wrong direction, one or two problems might come out of the woodwork.
That is the problem with hedge funds: when things are going in the right direction, they do wonderfully. However, even then, they tend to charge a higher annual management fee plus a performance fee and I am always sceptical about where those returns are going. I feel things are slightly weighted towards the managers than the clients.
In 2008, Warren Buffett made a bet with someone that the S&P 500 would beat a basket of hedge funds over the course of ten years. Six years in, the index is comfortably ahead.
In short, I think hedge funds are too complicated, too risky and too expensive for most clients. Some would argue for having a small part of a portfolio allocated to them. But why not just have that part in a traditional managed fund, rather than a complicated, expensive, high risk fund?
Ben Yearsley, fund analyst, Charles Stanley Direct
I am not really convinced hedge funds are needed anymore. There are plenty of other investments out there that look to deliver more of an absolute return style, compared to five years ago: things such as Troy Trojan or some of the more strategic style bond funds, as well as Artemis Strategic Assets or some of the absolute return funds in the unit trust world.
Hedge funds are put on a pedestal, as if they are the answer to everything, but you need to think about where you are investing. You might go to a hedge fund that is double geared, for example, thereby doubling your returns, but you are taking on huge risk to do that.
They are also expensive. It always amuses me that a lot of very wealthy people buy into hedge funds, happily handing over 2% per year plus a 20% performance fee, when there are some very good funds out there for a third of the cost.
I do not believe that hedge funds are an investment panacea. There are some good ones out there but, often, the ones you hear about making huge amounts of money when markets are falling are the ones taking massive bets on things such as commodities, currencies and sub-prime mortgages. Is that really suitable for the majority of investors? No.
If you are looking for diversification, within your ‘boring’ old unit trust, you have got broad sub-sectors such as agriculture, commodities, gold and so on.
In the investment trust space, you can get private equity, venture capital and so on, without the need to get into the more illiquid, complicated and regulatory hassle that comes with a hedge fund.
Caroline Winckles, deputy head of investment office UK, UBS Wealth Management
Investors typically think hedge funds are complex, illiquid, expensive and difficult to access. In fact, hedge funds play an important role as an overall return enhancer, a return diversifier and a volatility dampener in a portfolio.
Minimum investment levels have come down to attract investors, plus there are funds of hedge funds. Volatility is actually similar to corporate bonds, which most investors expect to include in their portfolio. And these days, investors are able to redeem more frequently with some funds, meaning investments are not locked up long term.
The performance of individual hedge fund strategies diverged significantly in 2013, ranging from a loss of 27 basis points for macro/trading strategies to a gain of 14.6% for equity-hedge strategies. This divergence highlights the importance of a balanced approach or careful strategy selection.
Following a big run-up in equities and higher expected interest rates, expanding investors' tool kits by having the ability to short the market and capitalise on larger corporate events makes hedge funds particularly attractive this year. Looking ahead, we expect hedge fund returns over five years of 4% to 6% with 5% to 7% volatility. This is attractive in an environment of lower expected returns across all asset classes.
Equity-hedge strategies are the best positioned this year as we expect company-specific fundamentals to drive stock price performance in an environment with low correlation and medium to low volatility. Idiosyncratic, sector and geographic differences should create divergences in earnings and provide numerous opportunities for skilled stock-pickers to generate excess returns on both long and short positions.
We continue to favour equity-hedge strategies, in particular, as opposed to ‘pure' directional strategies, such as macro/trading. We advise investors to increase exposure to equity long-short strategies. A favourable corporate earnings outlook and lower correlations among individual stocks support this strategy.
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