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Benefits and Pensions MonitorHedge Funds: A Misunderstood Asset Class
The term ‘hedge fund’ dates back to the first such entity founded by Alfred Winslow Jones in 1949. The foundation of Jones’ novel investment approach was ‘hedging’ his long stock positions by selling short other stocks to protect against market risk. He also used leverage ($1 long and $1 short for $1 of capital) to enhance the potential return on the partnership’s assets. In 1952, he introduced another wrinkle – a 20 per cent profits incentive fee for himself as managing partner. His entire liquid net worth remained in the partnership ensuring that his and his investors’ goals were aligned. As such, Jones combined the elements of a classic hedge fund in one vehicle – both long and short positions leading to market neutrality, active balance sheet usage, leveraging, incentive fees, and shared risk. While most of today’s hedge funds still trade stocks both long and short, they invest in a much larger range of instruments and strategies including currencies, sovereign debt, credit products, commodities, and all of the related derivative instruments. Generally, they are skill-based strategies with little dependence on market directionality for performance. As such, they are generally described as active ‘alpha’ providers rather than passive ‘beta’ exposures. Hedge funds used to be much less common, with a few hundred funds operating globally in 1990 with perhaps $40 billion assets under management. Currently, industry experts estimate that there is more than $1 trillion under management in more than 7,000 funds globally. The Case For Hedge Funds There is a general perception that hedge funds are dangerously high in market risk. However, contrary to that perception, the majority of statistical and intellectual evidence suggests that hedge funds are lower in market risk as compared to traditional portfolios. Since 1990, hedge funds have generated returns greater than equities with roughly one-third of the volatility, half the monthly draw down, and one-fifth of the total draw down, in addition to having low levels of correlation with equities and bonds. While hedge funds trade traditional assets, they do so in a very different fashion. This freedom of movement, coupled with the skill of the manager, means that a hedge fund could occupy a core position in many qualified investor portfolios. It is important for investors to understand this traditional assets- plus non-traditional trading- type method characteristic in generating hedge funds returns, as hedge fund returns, like all investment managers’ returns, are not going to be entirely divorced from the performance of the underlying asset classes.
Skeptics Claim Skeptics claims ‘hedge funds add no value’ and ‘the time for hedge funds has passed. Massive asset flows have removed all inefficiencies.’ In fact, hedge fund performance is roughly a function of the direction of equities and credit; the level of the risk-free rate; and volatility and correlations within and between asset classes. Overall, a solid trend to equities and credit, higher central bank rates, medium to high volatility, and medium to low correlations would be the best environment for hedge funds. The opposite – a state that we have experienced over the past few years – would lead to more muted returns. As well, the idea is that the (relatively) poor returns of the past two years are evidence of a secular decline as opposed to merely due to cyclical factors. However, the case of positive asset flows diminishing performance is ambiguous at best. In certain strategies – managed futures, equity market neutral, emerging markets, and convertible bond arbitrage – the historical evidence points to the opposite conclusion. The flows into the asset class have boosted returns going forward. Hedge funds represent a return of the asset management industry to its origins – investment partnerships focused on high absolute returns coupled with a focus on capital preservation. It also represents a new economic model whereby managers co-invest with their clients and are incentivized to deliver the best performance possible. Traditionally, within the purview of high net worth investors and sophisticated institutional investors such as the Ontario Teachers’ Pension Plan, they are now becoming more widely accepted and available to a broader class of qualified investors. Aleksander Weiler is vice-president – investment management, at Tremont Capital Management, Inc. |
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