Are hedge funds a genuine alternative investment option or a costly venture with little chance of earning real returns? Two industry experts debate the pros and cons
Tracy Pearson, head of alternative investment at Forsyth Partners, believes the case for investing in hedge funds is through fund of hedge funds
According to Pearson, hedge funds have proved their worth in providing investors with a genuine alternative investment option to other major asset classes, such as equities and bonds. Moreover, she says there are new strategies regularly emerging in the hedge space, including carbon trading, weather derivatives and direct lending, as well as hedge managers continuing to look for geographical opportunities in previously unchartered regions, such as India. She points out this trend for innovative opportunities in the hedge industry means managers should continue to find value in both fluctuating and saturated markets.
However, she adds: "Despite the massive expansion of the hedge universe in recent years, it can still be very inaccessible for even the most experienced investor." Pearson cites several reasons for this including high entry prices, forced lock-ups, funds being domiciled in less-regulated environments and the difficulty in sourcing quality managers with so many now working in the market.
She believes the solution to these constraints can be found in fund of hedge funds (FOHF) and argues the pooling of underlying funds into portfolios can significantly lower return volatility and increase risk-adjusted returns through the benefits of diversification, thereby providing both strategy and manager flexibility. She says the aim of a FOHF is to provide long-term relative performance, not to seek short-term outperformance.
She is well aware of the criticism surrounding FOHF, and adds: "It is true to say FOHF are not the cheapest investment option open to investors because they usually charge an initial fee, an annual management fee and the possibility of a performance fee too. But putting it into perspective, a FOHF offers a unique product for investors."
FOHF pool several hedge funds and strategies under one fund umbrella with the aim of providing access to the best talent (even those not usually available to single investors) and undertaking full due diligence and investment management on the underlying funds. Pearson says portfolios are normally constructed to spread risk by ensuring style, strategy and exposure to certain markets, and managers are adjusted and carefully monitored to avoid over exposure in any area.
For Pearson, one of the resounding benefits of FOHF is the price of entry. She says most hedge funds make investment prohibitive to smaller investors due to the amount they have to pay to enter a fund - often around the $1m (£527,288) mark - whereas FOHF create the opportunity to pool investments, therefore making the entry price much lower than investing directly in hedge funds.
She adds: "The greatest benefit of a FOHF for investors lies in the time consuming process of researching hedge funds, undertaking extensive and complicated due diligence and continuously monitoring and adjusting portfolios. Any fund research is incredibly daunting and many investors do not have either the resources or the skills needed to undertake it properly, particularly in a saturated and, in many instances, unregulated environment like hedge. So a FOHF allows investors to outsource such time consuming necessities to a team of dedicated experts, who are skilled in the high levels of research necessary to ascertain whether a hedge fund has the potential to be a sound investment.
According to Pearson, the level of research and due diligence is key to the service, but the fact FOHF managers can access potentially exclusive managers adds further value to the service. She says the pooling of resources in a FOHF offers this increased level of access and provides a more open relationship with underlying managers, resulting in an increased understanding of their styles and strategies.
Pearson is accepting of some of the cynicism surrounding hedge funds, but feels it is sometimes unjustified. "It is fair to say hedge fund managers are notoriously secretive about disclosing their methodology and as a result constantly come under criticism for lacking transparency. But hedging is not a simple process and the statistical, strategic and informational tools needed to hedge a position are by no means simple. For this reason a FOHF takes the time to understand a manager's style and process in order to source those that provide performance through skill and not market momentum."
She believes the popularity of FOHF will continue to rise, especially when it is realised the service provides long-term investment opportunities: "Hedge managers are constantly seeking to leverage fresh opportunities in this competitive arena and it is the role of FOHF to utilise these new developments without exposing a portfolio to unnecessary levels of risk."
Trend for innovative opportunities in the hedge industry
Aim of FOHF is to provide long-term relative performance
FOHF allows investors to outsource research, due diligence and monitoring
Robert Lockie, a certified financial planner at Bloomsbury Financial Planning, remains unconvinced investing in hedge funds is an option that most private investors should consider
Lockie believes the only investors who should consider investing in hedge funds are those who believe strongly in the concept of active management adding value. Hedge funds are merely an extension of the traditional actively managed approach, in that the manager believes he can exploit, and profit from, anomalies in the market but with hedging strategies, which can be either underpricing or overpricing. He explains: "Unfortunately for all active managers, the overwhelming evidence from academic research indicates active management, when compared to appropriate benchmarks that accurately reflect the composition of their portfolios, does exactly the opposite, particularly when costs are taken into account."
The reason why the composition of a portfolio matters, according to Lockie, is that research by Fama and French has suggested around 95% of a portfolio's actual return is determined by its exposure to five structural risk factors (for bonds, credit risk and duration and for equities, market, value and small-cap exposure). And while from time to time a minority of managers do beat the market, this is no more than would be expected on a random basis and there is no reliable way of predicting who such managers will be.
If the hedge fund manager cannot find many opportunities to beat the market over the long run, continues Lockie, their charges will be the main factor influencing the net return to the investor. A typical hedge fund charges a 2% annual management fee and 20%-35% of any positive gains, in addition to initial and exit fees. It is also not uncommon for a hedge fund to buy and sell 100% of its portfolio each month (based on a median 1,200% per annum (pa) for equity market neutral funds, as reported by UBS Warburg in 2001 and 800% pa for long/short equity funds). This compares to around 96% each year for a typical traditional active fund (according to Fitzrovia in April 2004) and around 20% each year for a passive fund (according to Dimensional Fund Advisors). Since trading always adds costs but does not always enhance returns, he argues the impact of such high levels of activity can be expected to have, on balance, a negative effect on the net returns.
With most forecasts suggesting future long-term equity returns of no more than 8%-9% pa, the investor in an expensive portfolio is unlikely to receive much, if any, real return over the long term, despite all the risk and loss of access to his capital.
He adds: "Given successful hedge fund strategies are founded on secrecy, investors are faced with a difficult task when it comes to assessing them, because managers tend to be reluctant to reveal either their compositions or strategies. This opacity makes it difficult to assess the extent to which apparent outperformance is attributable to skill because, without this data, it is hard to determine the appropriate benchmark for comparison.
The costs of researching individual hedge funds and the need to invest in excess of $100m (£527m) - according to research from UBS Warburg in 2000 - to make it worthwhile, makes a fund of hedge funds (FOHF) the preferred route for most investors. However, Lockie points out the drawback of a FOHF is the layer of charges (another 1%-2% plus a performance fee of 10%-20% is common), which make the hedge allocation the most expensive part of the portfolio.
With much of the information in the market coming from those with a vested interest in their promotion, Lockie prefers to consult the work of academics when considering their possible inclusion in portfolios. One such paper he cites (Stocks, bonds and hedge funds: not a free lunch) considers the diversification benefits of including hedge funds in a portfolio of bonds and equities, where hedge funds replace bonds and equities equally. It found the net impact was an increased probability of a large loss; an increased probability of a low positive return; a reduced probability of a smaller loss; a reduced probability of a high positive return with no diversification effects on the portfolio until the percentage in hedge funds rose to substantially more than the 1%-5% usually suggested by portfolio managers.
"Borrowing is another aspect of which investors are commonly ignorant. This helps to enhance returns when things go according to plan but as soon as they move against the manager, it serves to magnify losses. If interest rates rise, this magnifies the effect of any bad trades because the debt still needs to be serviced and the cost of doing so increases while the available assets have fallen," he added.
However, Lockie prefers to leave the last word to a leading hedge fund manager: "Do not confuse a great business like hedge fund management with a great investment strategy."
Hedge funds incur high charges, while a FOHF adds another layer of fees
High level of trading activity has negative effect on net returns
With hedge fund strategies founded on secrecy, it is difficult to assess them
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