Ever since they were first launched in the 1940s, hedge funds have been the object of envy, desire, lust, loathing, fear and hatred from many outside the industry and, indeed, quite a few within. Their bad reputation rests on their generous contribution to the 2008 financial meltdown.
But are they really all bad?
What’s in a name? Sometimes not much. Most hedge funds do not hedge themselves, the hedging part comes from the fund’s fee structure: generally two percent of assets under management are used to cover costs and 20 percent of the performance is levied as an incentive for showing performance. The watermark for this performance is usually very high, so the fund managers make extra sure they will not be losing money.
There are two basic ways to work the market. Either go long: buy, wait for the price to rise, then sell and pocket the profit. Or go short: sell a “borrowed” security, wait for the price to fall, buy it back and hand it back to the lender and pocket the profit. In other words, they offer the possibility of making money both in rising and falling markets. The funds can be invested in a variety of markets and using a range of strategies; as such, their returns will be linked somehow to whatever markets they are investing in, whether the correlation will be positive, negative or shifting is another question.
Finally, hedge funds are generally set up by traders who have left investment banks where they gained invaluable experience and established a track record. They are often ambitious individuals who would prefer working for themselves rather than haggle every year about bonuses and salaries. The point about managing their own money is key; hedge fund managers have this double incentive to avoid negative performance: not only will they not be able to levy performance fees till they return above their high watermark, but they also manage – and risk – their own money. If their investors lose money, so do the hedge fund managers. The key is to know where the border between risktaking and being reckless lies.
Given this goal of not losing money and the tools at their disposal, top hedge funds tend to have an impressive track record of performance, especially when viewed in the mid and long term: by avoiding or limiting losses when markets go bad and still capturing a decent share of rising markets, investors have seen strong and stable returns across full economic cycles. When reviewing these strong returns – and despite the omnipresent disclaimer that “past returns do not guarantee future performance” – it is worth bearing in mind that contextualising is of utmost importance, particularly when viewing historical performance data. 20 percent returns on an equity portfolio will always seem impressive. Viewed within the context of high inflation and high returns on fixed income does dampen the wow effect. So whilst the target of a hedge fund is to thrive in the mid and long term independently of market conditions, the absolute definition of “thrive” can radically change over time and it is wiser (and far les disappointing) to consider a definition relative to market conditions.
Many investors wax nostalgic when recalling the halcyon days of the 1970s, 1980s and 1990s, and many younger investors feel they were born a few decades too late. Government bonds offered very high returns with nearly no risk, default risk appeared as a surprise in a South American country and was unthinkable in Europe. Equity, too, appeared risk free (most of the time). A market that delivered high single digits on a specific year would be considered as underperforming and midterm double digits appeared not only attainable but also expectable.
As history supposedly came to an end (though the author of this term has since explicitly underlined that he did not mean it as is commonly understood), markets were supposed to thrive exponentially, and so they did throughout most of the 1990s. In the era of post-history, economics was supposed to be replaced by the economics of the Internet whereby the stock price of the largest bookstore in the world would rise dramatically, no matter how much money the store would lose based on a business model that was not yet ripe. Investors flocked to companies that produced nothing on the hope they would be bought up by others. They assumed either that these others were wiser than themselves (“since I don’t understand what this company does but someone is offering more money for the stock than what I paid, I must be a fool and they must know what they’re doing”), dumber than themselves (“I know it’s worth nothing but some idiot is willing to buy”), or a combination of the two (“whether or not I understand anything is debatable, but at the end of the day this is making money so lets neither ask not tell”). Ironically, the end of this bubble in 2000 came as a surprise to most, launching a decade of “no performance”. As a side note, this “lost decade” was only really “lost” if you invested in equities before the dotcom bubble bombed, took the full hit of that market crash, then took the full hit of the subprime crisis. Any investor who limited their downside during the crashes actually did rather well, as did anyone who invested in bonds, hedge funds or most commodities.
But before we move into the 21st century, let us look at how hedge funds did through the 1980s and 1990s. As mentioned, markets grew vigorously over this period and even mediocre managers produced good performance figures; a part of this was attributable to market beta, another part to alpha (whether that is a manager’s talent, or simply luck is another question), but overall this was a Golden Age for hedge fund managers. Many fortunes were made thanks to the many opportunities and uncrowded markets, and the industry grew more confident and more institutional, up to the point the hubris of some led to memorably shocking collapses: LTCM1 and Amaranth2 are probably the two best examples. The riches, amounts managed and the blowups all led to consolidate the myths and fantasies related to hedge funds.
Back in orbit
Quite naturally – and fortunately – the infamous crashes had a sobering effect on most managers: leverage was more and more frowned upon, mathematical models that couldn’t go wrong were sunk by black swans, and fund managers realised that, unlike in banks where the upside was a greasy bonus and the downside was the sack, when running their own fund their downside was also the loss of all their own invested money and, short of flipping burgers, they would have to submit resumes to their former employers. Risk-taking became more measured as mid- and long-term capital appreciation truly appeared more desirable than making a quick fortune. Combine the sobering effect of the blowups, the increased maturity of the business models with a stagnating economic environment: though the industry has, overall, generated alpha, returns have tended more towards single digits, inline with equity markets and bonds (not generating low single digits of interest). Given all this, why should any-one be surprised at lower hedge fund returns as compared to 20 years ago? All returns are lower than they were 20 years ago. Carry trading has become inexistent, volatility has been rising, and correlation between asset classes has been increasing, so expecting absolute uncorrelated regular and stable returns amounts to wishful thinking. It may be a fantastic pitch to market to clients, but it remains fundamentally dishonest (as most things that appear too good to be true).
It is however still possible to gain absolute returns by combining many alternative strategies; the end result will however produce increased volatility as few strategies still offer low volatility. Is this unfortunate? Yes. Is it realistic to expect hedge funds to deliver stable absolute uncorrelated returns? No, not unless you feel like investing in a Ponzi scheme (in which case you’d better be exceedingly good at timing your redemptions and avoiding clawbacks).
The riddle of diversification
In recent years, asymmetric long/short equity and equity event-driven funds have kept their promises, delivering a large part of the upside with a fraction of the downside, thus producing superior risk-adjusted returns over the midand long-term, whilst maintaining liquidity. What they target sounds less appealing than uncorrelated absolute returns, in the current environment (and probably for the next years), it appears more realistic, more sustainable and more profitable. When we take stock of the low returns to be expected in developed markets and the ability of hedge fund managers to produce some sort of alpha, it would appear natural to examine what can be done in emerging markets: these countries continue to grow and their public finances are solid, the middle class is rapidly developing and is consuming more and more. They are, however, underinvested in most portfolios as they do remain volatile. Some investors were hurt by the Latin American defaults and Asian crisis of the late 20th century.
The time has come to admit that the tide has turned, but once again many investors will wait for a few years of strong performance before changing their allocation, thus missing years of strong performance. Given, however, that for the time being volatility is and remains an issue due to market inefficiencies, market size and the panic reaction of investors who’ll withdraw their investments whenever the ride becomes bumpy, investors will be seeking a solution with which to reduce volatility whilst maintaining the strong performance of these markets.
This is where the combination of hedge fund managers’ know-how and emerging markets’ potential for performance becomes truly interesting. More markets have become efficient and now allow shorting. The inefficiencies exist but are more easily identified: In “normal” markets, managers can produce interesting returns and in up or down trending markets, managers too can either protect capital or even benefit from the swings. How should investors position themselves going forward? The choice appears to be between the following asset classes, which all have their advantages and disadvantages. Equities can perform well but are volatile and can be risky, bonds are stable and generally safe (well, until recently), but return very little, especially going forward. Commodities are very exciting, in a rollercoaster sense, so they are not everyone’s cup of tea (and gambling on people’s food is not for the scrupulous); private equity may have more upside (many times the investment) than downside (100 percent of the investment), but is both illiquid and requires sharp analytical skills. At the end of the day, unless you are yourself a trader (and are running your own hedge fund), investing your money alongside that of the world’s most talented traders does make a lot of sense, whether they invest in equities, bonds or commodities. Furthermore, hedge funds investments through fund of funds structures save investors from the risk on single manager investors, save the costs associated with travelling, due diligence and offer “prêt-à-porter” solutions.
Which markets will you invest in? Well, developed markets still have a few arguments going for them: stability, regulation, sophistication, low inflation; growth, however, in all likelihood will be lacklustre in the years to come. Emerging markets, on the other hand, will be having far more growth and the business case for investing in those markets is clear. Furthermore, investing through hedge funds will limit the downside and volatility, which are the two largest hurdles to investing. Perhaps the real question for investors should be which balance they wish to strike between the proportion of their portfolio invested in developed markets and that invested in emerging markets; in the vast majority of cases, they will find they are underinvested in emerging markets and, if they examine why, they will find that investing through an emerging markets fund of hedge funds will meet all concerns they have whilst offering them the desired participation in the growth of tomorrow.
Article by Bertrand Bricheux