Hedge fund performance has proved disappointing to investors expecting the 10%-15% returns of past years. Derek Stewart believes more realistic expectations combined with strategic asset allocation is the key to success
You have access to top managers, absolute returns, diversification, low correlation and capital preservation. So why are investors so disappointed with hedge funds today? They are disappointed because they have been sold the past performance.
Everyone is being sold the story of 10%-15% with low volatility ' the reality is that it is not happening.
Another problem that arises is time horizons. We have had investors go into our fund and then, after two months, go out. We have made them 1% over two months while stock markets are down 15%, but the returns are still not good enough. Time horizons need to be extended. Everyone seems to be looking at hedge funds on a monthly or a weekly basis. I have been asked: can you launch a fund of hedge funds where you have daily liquidity? The answer is no ' this would ruin the entire business.
I have never been a great believer in back testing and performance, and I also do not believe any of these averages or indices are a great indication. But a few points need to addressed.
If we go back 12 years, the average performance for hedge funds is 12.83%. They outperform both equities and bonds. From 1994, returns have come down to 10% ' still better than equities, still better than bonds. If we then go to the past three and a half years, hedge funds have come down to 8%. But I would still rather be getting that than -7% or 1% respectively in equities and bonds. If we move forward to the last few years, you can see why investors are discouraged. They have been sold these products at 12%-15%, but now are only making 3%. But you have to look at what is happening in the context of equity and bond markets.
If you have decided hedge funds are an interesting asset class and you have realistic expectations ' not 10%-15% ' you have then got to decide whether you do this yourself, or select a fund of funds manager.
It is not quite clear me some funds of funds add value. Everyone is charging fees, at an average of 1%. If you give someone $100m, then $1m will be in fees alone. You could probably do this yourself for that asset size. Obviously, if you have $5m, it would be difficult to do it 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 this does not guarantee success.
Strategy analysis is probably the most important factor before you select a manager. If you do optimisation and it tells you to put your money in merger arbitrage because for the last three years returns have been good, you would be extremely disappointed as you would not be making any money today. You have to to look forwards. With over 6,000 funds, you will not be able cover them all. No matter what anyone tells you in their marketing material, you cannot 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. I interview many people for jobs and the answers I get are weak. This is an example of an industry that is going through growth and development where there is a shortage of experienced people.
It all points to a herd mentality ' same database, same quantitative analysis, same optimisation, same managers and same results.
Strategies change, managers change and managers lie.
We did some strategy analysis on a manager in the US and we liked his strategy. It was small-cap, long/short. We then did some filtering on the universe. He had some $500m under management. We then went to visit the manager. My colleague and I sat through the meeting. We were trying to find out the manager's investment process and he could not describe it. With the power problems in the state we asked about the backup ' what would they do if something were to go wrong?
The manager's response was: 'We go to the beach ' what can you do?' He had $500m under management, a great track record and lots of investors so why is no one else asking these questions? We went to Tokyo to visit another manager and said: 'Show us examples of your research.' He turned his head towards a mountain of paper.
This is not 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 have yet to see something with back-tested performance that works going forward.
Back to basics
On strategy analysis, everything, no matter what, is driven by supply and demand. If you do not 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 the risk/return had been good 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 dramatically. If an opportunity looks interesting, there are so many funds of funds looking backwards, if the three-month figures look good, everyone is in there. It is clear to see ' if a manager has six or seven good months in a row, then their assets can go from $100m to $500m overnight. Clearly people are chasing returns.
Even within a strategy, risk/return profiles can be very different. If you take distressed, for example, you have to decide if you want to be in the high-risk part of distressed or the low risk. If you invest in a distressed company and you buy the bank debt or the senior secured bonds, this is the lowest risk area. However, if you buy 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, it is essential to look at the drivers.
Both strategies are event-driven, but distressed will work better in a bear market ' opportunities are created in a downturn, while for merger arbitrage opportunities are created in an upturn. If you are deciding where to put your money ' distressed or merger arbitrage ' and you abdicate responsibility and equally weight it then you are not doing your job properly.
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 is no guarantee, but at least if you know what is 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 scrambling out of merger arbitrage because they are making negative returns. So what we have seen is 50% of the capital that flowed in has now disappeared. Therefore, we will begin to look at merger arbitrage again because the supply of opportunities will come back at some point and the demand aspect has gone.
There is a tendency in the industry to say, 'we have given them money, let's move on to the next idea.' But the biggest risk is the manager you have already got money with, not the one you might put money with later.
Hedge fund performance must be viewed in context of what is happening in equity and bond markets.
Quantitative techniques and reliance on optimisation are backward-looking techniques. Investors need to look forwards.
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