The increasing popularity of hedge fund investment in a bearish environment has generated a herd mentality and it needs to be emphasised that funds are event driven and past performance is a poor guide to future prospects
If you are looking to invest in hedge funds today you need to adopt a cynical approach.
It is my opinion that 90% of the industry is based on past performance, optimisation and quantitative analysis.
Each one of the following aspects is crucial to your investment decision:
• Are your objectives realistic?
• Does your fund of funds manager add value?
• What are the challenges facing the industry as it grows?
• Why should anyone invest in hedge funds?
Everyone thinks about hedge funds as a fourth asset class and consultants like to wrap everything up into a pretty package. But in reality it doesn't matter whether you call them an asset class or not. What does matter is where you get the best risk-adjusted returns ' equities, bonds or cash?
Over the past 12 months, bonds have been the best asset class in which to invest. Over the past 10 years, they have been pretty poor performers.
Why are so many people disappointed with hedge funds? After all investors have access to top managers, absolute returns, diversification, low correlation and capital preservation, so why are they so disappointed today? In my view they are disappointed because they have been sold the past performance story.
Everyone is being sold this 10% to 15% with low volatility story. The reality is that it is not happening. Another problem is time horizons. We have had investors go into the fund, then go out after two months.
We have made them 1% over two months, and despite stock markets down maybe 15%, they have decided the returns are not good enough. I think time horizons have to be extended.
Everyone is looking at hedge funds on a monthly basis or a weekly basis. I have been asked whether you can launch a fund of hedge funds where you have daily liquidity. That would just ruin the entire business.
I'm not a great believer in back testing and performance. I also don't believe any of these averages or indices are a great indication. But I want to point out a couple of things. If we go back 12 years, the average performance for hedge funds is 12.83%, outperforming equities and bonds.
From 1994 onwards, returns have come down to 10%: still better than equities, still better than bonds. If we then go to the last three-and-a-half years, hedge funds have come down to 8%. But I would still rather be getting that than '7% or 1%.
If we roll forward to the last couple of years, you can see why investors are disappointed. They been sold this 12% to 15% story but now they are only making 3%. But you have to look at what's happening in the context of equity and bond markets ' I'd still rather be up 3% than down 24%.
If you have decided that hedge funds are an interesting asset class and you have realistic expectations, not 10% to 15%, you have then to decide whether you do this yourself or select a fund of funds manager.
It is not quite clear to me how some funds of funds add value. Everyone is charging fees, and if you the average fee is 1%, that is $1m in fees from a $100m investment. You could probably do that yourself for that asset size. If you've got $5m, it's going to be very difficult to do that yourself professionally.
What I see today are the quantitative techniques, reliance on optimisation, which is backward looking ' where you should have had your money, when you want to know where you should put it going forward. Anyone can buy a database for $30,000 but it's no guarantee of success.
Strategy analysis is probably the most important factor before you select the manager. If you do optimisation and it tells you to put your money in merger arbitrage because for the past three years returns have been good, you would be extremely disappointed because you wouldn't be making any money today. You have to look forwards.
There are over 6,000 funds, so you cannot cover them all. No matter what anyone tells you in their marketing material, it is impossible to cover 6,000 funds. So you have to decided where you are going to specialise.
The research I see being done today is of extremely poor quality and the reason I say that is because I interview many people for jobs and the answers we get are weak. That is an example of an industry going through growth and development where there is a shortage of experienced people.
I'm beginning to see a herd mentality: same database, same quantitative analysis, same optimisation, same managers, same results.
We did some strategy analysis on a manager in the US and we liked his strategy. which was small cap, long/short. We then did some filtering on the universe.
We then went to visit the manager, who had $500m under management. The fund was based in San Diego, it took us 11 hours to get there by air. My colleague and I sat through the meeting. We were trying to find out the manager's investment process and he couldn't describe it. With the power problems in California we asked about the back-up ' what do they do when something goes wrong?
We went to Tokyo to visit a manager and asked him to show us examples of his research. He turned his head and there was a massive pile of paper. That isn't a process or discipline we can understand or put our investors' money in.
There are no short cuts in this business. It can take three to four months to go through the process and find one manager. It can take three to four minutes of quantitative analysis to select the best portfolio in the world but I've yet to see something with back-tested performance that works going forward.
On strategy analysis, everything, no matter what, is driven by supply and demand. If you don't know that merger arbitrage opportunities are driven by M&A activity, you are going to be in the wrong place. At the end of 2000 everyone was allocating money to merger arbitrage because of the risk/return over the previous three years.
It has been one of the worst for the last two years. Today there is so much money going into hedge funds that the time horizons have shortened. If an opportunity looks interesting, there are so many funds of funds looking backwards that if the three-month figures look good everyone is in there.
You can see it: if a manager has six or seven good months in a row, then their assets can go from $100m to $500m overnight. To me that is clearly people chasing returns.
Even within a strategy, the risk/return is very different. If you take distressed debt, you may think that distressed is a great opportunity. You then have to decide if you want to be in the high-risk part of distressed or the low-risk part. If you invest in a distressed company and you buy the bank debt or the senior secured bonds, that's the lowest risk area ' if buy the equity, there is a chance you may lose all your money but there is also a chance you may make a high return.
You cannot look at 100 convertible arbitrage managers and assume they are all doing the same thing. There are probably four or five distinct strategies there and you have to be clear which one you are in.
If you compare distressed with merger arbitrage strategies from 1987 to 1993, you want to be looking at the drivers.
Both strategies are event-driven, but distressed works better in a bear market since opportunities are created in a downturn. By contrast, merger arbitrage opportunities are created in an upturn. If you're deciding where to put your money, distressed or merger arbitrage, and you abdicate responsibility and equally weight it then you're probably not doing your job.
The decision may not be clear ' we had 60% in merger arbitrage several years ago, 0% distressed. Today it is more like 40% distressed, 5% merger arbitrage as there was a clear shift in the economic environment. Sometimes it is not that easy and there's no guarantee but at least if you know what's driving that strategy you are more likely to be placed there.
If you look from 1987 until 1993, the returns from merger arbitrage were 15% and the volatility was 3%. Now we are seeing all the people who were allocated to that are scrambling out of merger arbitrage because the returns have come down, the volatility has come down and they are making negative returns. So what we have seen is 50% of the capital that flowed in has now disappeared so we will start looking at merger arbitrage again because the supply of opportunities will come back at some point and the demand aspect has gone.
The biggest risk is the people you have got money with, not the one you might put money with in the future. There is a tendency in the industry to say: we have given them money, let's move on to the next idea.
Don't get sold on the past-performance story on hedge funds and look to the longer term.
Check out the fund's strategy ' it is present economic trends not past optimised returns that count.
Beware of weak research ' a fast-growing industry is running short of experienced personnel
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