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Benefits and Pensions Monitor

A Closer Look At Hedge Funds

By: Lance Speck

Based on the amount of literature devoted to the subject of hedge funds, the number of hedge funds in existence, and the amount of money dedicated to the sector by sophisticated pension funds, there is the appearance that hedge funds are a special asset class in the investing world. Although they have not yet become part of the lexicon of most investment policy statements, there is considerable recognition that a fully up-todate policy statement would include some exposure to hedge funds.

Based on compound annualized returns, the hedge fund industry has in aggregate produced some quite respectable returns over the past five years. The CFSB/Tremont Hedge Fund Index has generated a five year average annual return of 6.7 per cent versus the MSCI World Index of -2.5 per cent, a positive spread of 9.2 per cent per annum. An impressive statistic given that this is net of all management and performance fees.

The picture, however, changes somewhat if one looks at the three year annual numbers. On a three-year basis, the CSFB/Tremont Hedge Fund Index has generated an average return of 9.3 per cent versus the MSCI Index of 6.93 per cent, a positive spread of only 2.4 per cent.

It is clear that the key to the strong Hedge Fund performance is related to the fact that the hedge fund industry produced positive results in the years 2000 to 2002 when the MSCI World Index produced some very large negative returns (See Table 1).

The great untold secret in the hedge fund industry is that comparing hedge funds to equities is comparing apples to oranges.

Apples Versus Oranges
The clue to the apples versus oranges analysis is within the hedge fund industry itself. The CSFB/Tremont Hedge Fund Index is comprised of the entire universe of hedge funds compiled into 10 sub-indices much like the MSCI World Index is comprised of 10 sub-industries. The list of the sub-indices reads like a shopping list of asset mix strategies. For example, how is a hedge fund strategy labeled ‘Macro Call’ any different than adjusting a balanced fund asset mix between fixed income securities and equities? How is ‘Emerging Markets’ different from allocating a portion of an equity portfolio to Emerging Markets? And then there is my personal favourite, ‘Multi-Strategy’, which sounds much like what most equity managers simply refer to as an eclectic approach to the market. The point is that whatever hedge funds might have been in the beginning, they are now starting to resemble a collection of investment styles in the same way that growth is an investment style.

Hedge Fund performance relative to the median balanced fund performance reveals a different picture than the usual comparison of hedge funds versus the MSCI World Index (See Table 2).

Two observations can be made from this table.

First, the performance advantage of hedge funds relative to balanced funds is less obvious than it was against a pure equity benchmark. Second, the performance advantage has been diminishing in the past few years. This is worth noting given that the serious growth in the hedge fund industry has only taken place during this same period. Hedge funds have moved from being a rounding error in the pension universe asset mix in 2000 to being a whopping 7.5 per cent of the U.S. pension universe. Total hedge fund assets now total just under $1 trillion.

If hedge funds are a style rather than an asset class, then one should expect the industry’s performance to ebb and flow depending on market circumstances much in the same way that growth and value styles ebb and flow.

Essence Of A Hedge Fund
The essence of a hedge fund is that it exploits mis-priced opportunities in the market. Looking back at the market over the last 10 years, one of the most significant periods of mis-pricing in a few decades can be found. Beginning in the mid-1990s, growth stocks began a period of outperformance that by early 2000 had created one of the largest gaps in valuation between growth companies and value companies ever seen. The gap was fueled by exponential growth in the use of the Internet and in spending to resolve the feared Y2K problem. This combination resulted in growth stocks, which happened to comprise the bulk of the S&P 500, becoming materially more expensive than value companies.

With the valuation decline of the growth stock universe, the valuation gap between growth and value has narrowed. There are now fewer opportunities to be ‘arbitraged’ for profit. Indeed, this has become a complaint of a number of large hedge funds.

As well, some of the hedge funds that were early to the party are now unwinding and returning capital to their investors.

In short, the ‘style’ is no longer working and may not for a while until another valuation gap emerges.

Lance Speck is a member of the senior portfolio manager team at Seamark Asset Management.

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