Martin Harrison of GAM talks about hedge funds as a complementary investment, and the performance of equity markets
Comparing the major equity markets of the world from the start of April 2000 until mid-October 2001 shows there has been no place to run. The worst performing index has been the MSCI Far East ex Japan, which dropped -49.3% over that time. The MSCI Japan dropped around -45%, MSCI Europe -30%, the S&P Composite sank -27% and the FTSE All-Share dipped -26%. The best performing market over this period has been South Africa but even SA has seen a dollar loss of -21.7%
Martin Harrison, director of mutual funds for GAM, says: 'However well you have done for your clients, telling your clients they have performed relatively well does not go down too well, does it? And this is where we think we come in. I must say at the outset that we do not advocate hedge funds as an alternative to investing in long-only funds; we believe hedge funds are a very good complementary investment if carefully selected.
'We use these funds because it enables us to reduce volatility. It can reduce volatility on the way up as well as on the way down, but we manage to cushion falls when long is falling strongly.
'The trouble with hedge funds is that they do not have a very good reputation. Something that springs to mind is something that is very risky, which is okay for rich people to speculate with some of their money. But I would contend that things are not the way they first appear. We call it the 'risk illusion'.'
The chart shows the worst 12-month performance of three indices over the last eleven and a half years, the S&P500, the S&P Banks index and the HFR market neutral index. Unsurprisingly, given the low-volatility of market neutral funds, the hedge funds index was the least bad.
Harrison says: 'We would certainly agree that in most market conditions a good mix of equities, bonds and cash will produce pretty quickly some good results. Unfortunately, from time to time, we get tremors and occasionally we get severe tremors.
'So what we like to do is add two additional asset classes ' equity hedge and trading funds. Both of these are hedge strategies, but both are quite different. By adding these two asset classes we can reduce the volatility of the overall portfolio.'
Hedge funds are still a misunderstood asset class. Harrison concedes that it is difficult even to find a good definition of a hedge fund. However, it is true that hedge funds are designed to provide attractive rates of return while maintaining low correlation with more traditional asset classes, equities and bonds.
Equity hedge funds target to achieve positive returns in all market conditions. They have low and sometimes zero correlation with equities and bonds and this is what differentiates them from trading funds: they only invest in equities. But they invest in equities on the long side ' the manager buys the stocks they like ' and they sell short where they think stocks are going to decline.
Also, a hedge fund tends to have more flexibility in terms of holding cash than a long-only manager.
'Equity hedge strategies come in various forms,' says Harrison. 'The first category is the plain vanilla long/short strategy, but there are also more specialist strategies such as merger arbitrage.'
How to make money
The long/short equity fund makes money in three ways: through its long position and its short position, but also through managing his net market exposure. There are some managers who are 'long-biased' managers, who remain net long most of the time.
'The second category is market neutral,' he says. 'Market neutral managers always maintain a zero net position to the market. Longs and shorts always match. As a consequence of that, the performance they generate is what we call pure alpha. It is the ability of the manager to pick stocks with long positions that perform better than the stocks he picks with short positions.
'A true market-neutral fund will not be taking a long position in technology and a short position in auto, because there would be some market direction that would come through from that. He should be pairing stocks that are similar, so he could take a long position in Microsoft and a short position in Cisco. It would have to be at least within the technology area.
'Then there is merger arbitrage ' this is a more specialist area of long/short equity. It has been a very interesting and good way of making money up until about six or 12 months ago. But it is not a good area to make money at the moment.
'This is where the manager focuses entirely on stocks that are involved in a takeover. In many cases when company A takes over company B, the target stock performs well, the one that's doing the buying does less well.'
It is not quite as simple as that, but the duration for the trade is around six months and the primary risk is that the deal falls through.
'Another, and we think much more interesting, form of arbitrage is bankruptcy/distressed. It does not sound very exciting, but it is at the moment. There are some extremely good opportunities here and the reason is simply supply and demand.'
Where a company announces that it is ' in the US ' in chapter 11 bankruptcy, the bankruptcy arbitrageurs will put a value on the equity and the debt.
'What often happens in a bankruptcy is that not only do equity investors sell out, but often so do the bond buyers,' he says. 'And they will sell out at almost any price.'
Even the secured debt is marked down to maybe 60 cents in the dollar. And this is even though that investment is fully secured against assets in the company.
This is shown by the fact that there is a huge oversupply of distressed debt in the US ' probably five or six times the amount of money that is there to mop it up.
Trading funds are the other broad hedge funds type GAM uses. They can invest in interest rates, currencies and commodities. Even equities can form part of their book. There are several basic types of strategy:
Global macro ' run by the likes of Julian Robertson and George Soros. These are individuals whose business is to take a view on global imbalances ' with the thought that these balances will correct themselves over time.
Soros has often been accused of forcing Britain out of the ERM, but that is not GAM's view.
Harrison says: 'We do not believe that at all ' we believe these managers are surfing on the wave ' it is just that the end result may have happened faster than it would otherwise have done.'
Systematic managers use computer systems to find trades that they can make money out of. These systems can be pretty sophisticated ' many managers have Phds.
'However, I can see why that is a bit worrying ' it is a bit like flying an aircraft without a pilot. But these systems have inbuilt risk controls
Relative value managers trade between two very similar types of assets ' for example corporate bonds versus treasury bills.
The worst performing index from April 2000 until mid-October 2001 has been the MSCI Far East ex Japan.
Hedge funds can provide a portfolio with a way to dampen volatility.
Women and young people adversely affected
A question of selectivity
Watchdog interviewed 13,000 people