Once deemed to be the asset class of the rich and privileged, hedge funds are known for performing well during a bear run. But do these fast-growing investment vehicles make good offshore products?
When it comes to offshore investing, most people think of gin palaces, white suited expats and sun drenched isles. But offshore is home of the hedge fund, one of the fastest growing products worldwide.
Hedge funds have traditionally been associated with privilege. The reserve of the rich and professional investors, they were brokered in the oak-lined power halls of leading investment and private client banks. This invariably involved significant sums of money and high-level management.
However, we are increasingly seeing the launch of retail hedge funds, significantly increasing their accessibility. Annual growth in hedge funds investment has been running close to 34% (Merrill Lynch and Cap Gemini Ernst Young) and more than 6,000 funds worldwide now control assets worth more than $500bn (FSA discussion paper).
This has undoubtedly been spurred by the perception that hedge funds, using short strategies, can perform well in bearish market conditions. And with markets suffering the largest investment boom bust cycle since the Wall Street Crash, it has been a bumper time for contrarians.
With this in mind, should investors be looking to put their money into that most enigmatic of offshore investments, the hedge fund?
In answering this, it is important to understand hedge funds. This is made difficult as there are so many different types of hedge fund and strategies that they can use. Many of these strategies can be extremely high risk.
For example, hedge funds managers can use gearing to invest more than the fund's entire capital. This means they can use loans to buy shares in firms they think are attractive, or boost investment exposure to low risk investments. In theory, they can also make money in falling markets by selling short.
Nearly half of all hedge funds are long/short funds, working on the strategy of reducing risk by owning some shares and short selling others. This involves agreeing the sale price of a share and the price it will be bought back for over a set period of time. If the share price falls, the fund gains. Conversely the fund loses if the share price rises. Since this is trading on 'borrowed' stock, there is an inherent execution risk in this strategy.
Relative value hedge funds try to arbitrage away differences in the price of two assets that have virtually the same economic characteristics. The funds gain by correcting mispricing between the assets. Merger arbitrage funds, for example, try and second guess share price movements of firms that have announced mergers but not yet completed them. Market netural hedge funds aim to insulate against stock market fluctuations, a strategy which works better in bearish than bullish markets.
However, the hedge funds that are generally available to retail investors are funds of hedge funds. Because of the complexity and variety of hedge products, a high degree of expertise is needed to select the best performing funds.
Since this is inherently extremely risky, a number of fund managers now offer funds of hedge funds, which invest in a number of other hedge funds. The other clear advantage of this strategy is that it massively reduces the minimum investment level, making hedge fund exposure available for more people. These funds are also available onshore, and are subject to UK regulatory jurisdiction.
So are hedge funds a good investment prospect? Although past performance is accepted as no guide to future returns with conventional long funds, it is even more redundant with hedge funds. Because of their gearing and derivative based strategies, conventional research is more difficult to undertake. Third party research on the sector also remains limited, with only a few very good information providers such as Allenbridge offering in depth analysis.
There are also fundamental structural problems with certain types of hedge fund, and in particular with the creation of bubbles. When numerous investors place more money into one hedge fund, this could decrease their effectiveness.
For example, relative value hedge funds have a physical monetary limit to the gains available from the arbitrage.
Consequently, if more money flows into the fund, this will reduce the rate of return for the investors involved in it. If average returns fall, managers may be tempted to increase their risk by borrowing money to multiply their stake, thereby compounding the risks.
This problem can be avoided if relative value funds don't allow new investors to join. Clearly funds may be tempted to grow bigger to take advantage of higher fee income. However, when they do this they may find it harder to invest money without the market turning against their positions, which in turn will lead to a fall in returns.
The greatest uncertainty about the future of hedge funds lies in the management charges and more specifically the performance fees taken by managers. A typical performance-linked fee is around 20%, although some fees are now as high as 50%. This is levied on top of a manager's annual management charges.
Consequently, more than 20% of any annual increase in a hedge fund will go to fund managers. This could incentivise a fund manager toward excessive risk taking. Bear in mind also, the additional layer of charges imposed by fund of fund vehicles.
Managers are not penalised if a fund's value falls, and consequently investors bear the brunt of any fall in hedge fund value. Additionally, if a fund is not performing a fund manager can always wind down the fund and restart afresh. This is not a luxury afforded to the investor.
Furthermore, the great increase in hedge fund investment has led to large amounts of money chasing few quality opportunities. There has been a great increase in the number of fund managers starting hedge funds to cash in on current investment trends (the 6,000 offshore hedge funds make the bloated UK unit trust sector look lean). This has led to inexperienced or ill-qualified fund managers, undoubtedly diluting the quality of hedge fund opportunities.
This is reflected in past performance figures although, as stated earlier, this is no fair indication to future prospects. Only one in 10 hedge fund categories delivered returns, after fees, equivalent to the returns of the S&P 500 over five years. Indeed the past indicators of hedge funds indicate that the single biggest factor in choosing a successful fund is selecting a sufficiently good manager with a disciplined process. This obviously has to be chosen with immense care and as much research and knowledge as possible.
So what is the future for hedge funds? The first signs of falling performance fees indicate that the industry is starting to mature, and reflect more closely consumer demands. The move into the retail market space also means that hedge funds may come under greater scrutiny from international regulators and other consumer-centric organisations.
However, the FSA published is DP16 paper on hedge funds last August covering, in particular, onshore managers of offshore based hedge funds. This centres on ensuring that the UK based fund manager has adequate systems and controls (though not for the underlying assets, which may be registered offshore and outside the FSA's remit).
The paper concluded that their current approach would suffice in future, indicating that onshore based managers are unlikely to face any additional regulation beyond that faced by the rest of the financial services industry.
Nonetheless, until greater transparency is introduced into the system, hedge funds must be considered only for the more experienced investor (indeed they cannot be marketed direct to UK retail investors under current regulation).
They may be the most exotic of the offshore product suites, but the risks are undoubtedly high and the returns uncertain. However, a well managed long-short equity hedge fund can provide a degree of diversification, particularly in larger portfolios.
Although the increased popularity of hedge funds is undoubtedly due to uncertain market conditions, it is worth remembering that they have performed poorly in previous bear markets. Indeed their performance in the 1970s bear markets was so dire that their inventor, Alfred Winslow Jones, famously stated 'the hedge fund doesn't have a terrific future'.
Investors should bear these words in mind before rushing into the high risk, uncertain return world of offshore hedge funds.
Only one in 10 hedge fund categories delivered returns after fees equivalent to S&P 500 over five years.
Performance-linked fees are as high as 50%, which could lead to excessive risk taking.
A lot of money is chasing few quality opportunities.
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