Avoid unnecessary risk
and lacklustre hedge fund returns

One of the fastest growing sectors of the financial services industry is the hedge fund or “alternative investments” sector, currently estimated at over $1 trillion in assets worldwide. One of the main reasons for such interest is the performance characteristics of hedge funds—often known as “high-octane” investments. Many hedge funds have yielded double-digit returns for their investors and, in many cases, in a fashion that seems uncorrelated with general market swings and with relatively low volatility.
Long the province of foundations, family offices and high-net-worth investors, alternative investments are now attracting major institutional investors, such as large state and corporate pension funds, insurance companies and university endowments, and efforts are under way to make hedge fund investments available to individual investors through more traditional mutual fund investment vehicles.

Adrian M Baumann, CFA, is CEO of CAYROS capital AG, a fully independent Swiss asset management company that specializes in alternative investment strategies, so-called “non-traditional investments”. CAYROS services are available to everyone who believes that CAYROS can add value to their existing investments and financial setting.

For further information, visit their website at www. cayroscapital.com or call AngloPhone on 0900 576 444 (CHF 3.12/min).

What is a hedge fund?
Many institutional investors are not yet convinced that “alternative investments” is a distinct asset class but rather a mongrel categorization that encompass a wide range of different investment objectives, strategies, styles, techniques, assts and markets, offering a wide spectrum of risk/return profiles.
For the sake of this article, we do, however, use this broad definition that a hedge fund is an investment vehicle that is loosely regulated and which follows a strategy free of any restrictions using all types of financial instruments.
Why invest in a hedge fund?
The principal argument behind hedge fund investing is that great inefficiencies occur—and will continue to occur—and therefore opportunities arise that enable investors to exploit mispriced securities without incurring excessive levels of risk. A key element is the talent of the manager (ie manager skill or alpha) to identify them and turn them into profits.
A second argument is that the approach of hedge fund managers is different from that of conventional long-term-only managers. Hedge funds aim to minimize directional market risk, while maintaining steady absolute returns, rather than relative performance against a stated benchmark index, typically the goal of traditional buy-and-hold managers.
And lastly, managers have generally significant personal stakes in their funds alongside investors’ money, which ideally aligns both interests.

The above comparison between a broad hedge fund index and the two main traditional asset classes clearly illustrates the superiority of hedge funds. Not only have they generated above average returns in the past, but also in a manner that is less risky than comparable investments (expressed as Sharpe ratio) and therefore make them a very attractive alternative “asset class”.

What are the current trends in the hedge fund industry?
√ Greater institutionalization (convergence to classical asset managers/consolidation)
√ Increased regulation
√ Increased asset flows
√ Sustained periods of low volatility
√ Longer lock-up periods
√ No reduction in fees
√ Active expansion into new trading areas and regions

And why are some of these trends leading to a lower return environment—against what most hedge fund investors have traditionally expected; namely, high returns in exchange for the corresponding risks that they are expected to bear?
It is common knowledge that the most talented managers are drawn first to the hedge fund industry because the absence of regulatory constraints enables them to make the most of their investment acumen. However, there is a gap opening between institutional investors and hedge fund managers due to a different business culture, regulatory oversight, investment mandate, etc, which impedes the exploitation of manager skill. Even though both groups do share the common goal of generating superior investment performance for their clients, the constraints of institutional investors often fall short of this goal and have led to the exact opposite.
Secondly, too much money flowing in the industry has attracted less skilful managers, who are simply lured to the high-income opportunities. Moreover, too much in a fund can make it less agile and unable to get out of positions quickly. In essence, overcapacity, both in the industry and in a fund as a whole, as well as the influx of less qualified managers, can compromise returns that justified an investor’s decision to get into hedge funds in the fist place.
Finally, increased observations of lacklustre returns are not only due to the low interest rate environment or the manager quality but stem more predominantly from the investors themselves. Due to the institutionalization of the industry the focus has increasingly been put on the volatility of returns and therefore generated an ever growing group of hedge fund managers who are risk averse and investing along these lines. A low volatility is not only a by-product anymore, but has become the principal focus of a hedge fund strategy.

How can you avoid being trapped with lacklustre returns?
The beauty of such a huge industry is that there is always room for the unique and the non-conformist. So why rely on big institutional names when niche players such as CAYROS can help you to select managers who are unwilling to work under such institutionalized terms, but who are committed to generating attractive absolute returns with a relatively low level of risk? CAYROS offers its clients a pool of talented, experienced and hungry managers who are passionate for their craftsmanship. We avoid size managers and select the ones where the performance compensation is still the predominant income source and significant own money is invested in their funds to align the interests of the client, the manager and the adviser.
Contrary to the institutional investor, we believe that because of the complexity and multifaceted nature of investing in hedge funds that it is best done through qualitative judgment and is simply not amenable to quantitative analysis only. Why? Because in a purely quantitative selection process—in which hundreds and hundreds of managers have to be screened according to rigid quantitative requirements such as lowest possible volatility or maximum drawdown, highest possible Sharpe ratio, etc—the non-conformist manager, who is not going with the flow, will simply fail to qualify for being selected.
In essence, CAYROS’ job is to stay away from the crowd to avoid the average and to identify the pearls that can be expected to generate attractive absolute returns in the future. Being small and having a wide-ranging personal network in the hedge fund industry is rewarding and offers room and time for independent qualitative judgement. Common sense still leads to the best results in selecting the right manager and having the manager being co-invested in his own fund is still the best risk management guarantee.