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Benefits and Pensions MonitorHow Do Hedge Funds Work?
If there is a season for every type of investment, now is certainly the time for hedge funds. On both the institutional and retail side, few topics and products have received as much attention. Yet for all the words that have been written, the question of how hedge funds make their money, and how they interact with each other, often goes unasked and unanswered. Two recent studies shed some light on the subject. In Hedge Funds: What Do We Know? (Edwards and Gaon, Journal of Applied Corporate Finance, Fall 2003) the authors note the difficulties of defining precisely what a hedge fund is. They note the generally used definition of hedge funds as an ‘alternative’ asset, generating returns that are relatively uncorrelated with returns on long positions in either stocks or bonds. The authors also note the difficulty of obtaining performance numbers that do not suffer from either selection or survivorship bias. Yet despite these limitations, they conclude that the returns from hedge funds have been strong over several time periods, especially when compared to traditional asset classes like stocks and bonds. This is true even on a risk adjusted basis. But why should hedge funds be able to earn these excess returns. The authors suggest several possible reasons for this: Better-informed, or more highly skilled, managers will be attracted to the higher compensation levels of hedge funds and will thus self-select. Hedge funds can employ investment strategies that mainstream investment institutions, like pension funds or mutual funds, are unable to pursue due to regulatory constraints. This includes the ability to sell short, the use of leverage, the ability to concentrate investments, and fewer constraints on investing in illiquid areas.
The idea that hedge funds are so distinct and independent of the overall market, is further examined in an unpublished paper by Djerroud, Ledgerwood, Rudd and Seco (Are Market Neutral Hedge Funds Really Neutral? (www.sigmanalysis. com/publications.html). They note that much of the interest in hedge funds comes from the perception that they are market independent, they can make an absolute profit whether the market is moving up or down. Yet do the so-called Market Neutral funds, and in particular Long/Short equity funds, which combine long positions with offsetting short positions, live up to their name? By comparing the return characteristics of a universe of Long/Short equity funds to that of the equity market, the authors conclude that there is a significant long bias. In bull markets, 85 per cent of the funds exhibit a positive correlation. In bear markets, 74 per cent show a positive correlation. To counteract this bias, one would typically suggest an asset allocation model holding funds that are uncorrelated to each other. Yet while this may hold in normal market conditions, under times of ‘market stress’ the protection that is needed through diversification is actually unavailable. During distressed market conditions, a significant proportion of Long/Short Equity Funds become highly correlated to each other. This observation doesn’t just hold with one category of hedge funds. With the exception of shortselling funds, which are negatively correlated to most of the funds, there is a shift to highly positive correlations when the market undergoes a transition from a normal to a distressed state. This is the case for funds ranging from convertible bond funds and eventdriven funds to merger and fixedincome arbitrage funds. If this is the case, then investing in a hedge fund is not a panacea. Market Neutral funds are not market-independent. In addition, diversification among hedge fund strategies alone does not insulate the investor from the downside during distress times – just when you need it the most. You need to work at it – incorporating data from different periods to produce an effective portfolio. The payoff is above average returns – surely worth all the effort. Jim Helik is co-author of ‘Energy Markets Risk Management,’a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University, in Toronto. |
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