Overview

            The economy at the close of 2010 may be on the verge of ending its deepest recession since the Great Depression.   Although unemployment remains high, if the stock market is any indicator, things may be turning.  The Market has gone in only one direction since August 2010, vertical.  Nonetheless, the S&P 500 is at levels below its closing price at the beginning of the decade.  Ten years of investing and most mutual funds and passive indexers have nothing to show for it.   And that’s not even counting the loss of value due to inflation.

          A prudent person would wonder why anyone would bother to invest in the market, yet Americans have been lulled into believing that a buy and hold strategy in investing will certainly lead to better investment returns than can be earned in bonds, certificates of deposit, and real estate.  If anything, Americans’ allegiance to the stock market has grown.  The baby boomers, representing one of the largest demographics in the United States, also represent one half of total U.S spending power.[1]  A recent survey[2] found a “historically unprecedented” exposure to the stock market, with 62 percent reporting stock holdings in 401(k) s, IRAs, mutual funds, or other vehicles.  The echo boom generation, the children of the baby boomers are entering the work force in masse.  As they begin to save and prepare for future needs, the investment choices are limited.  With historically low interest rates, a real estate market that is in decline, and few alternatives, the likelihood of continued interest in stock market investing is high.  Hedge funds are meeting this need.

           Privately offered, professionally managed pooled investment vehicles are popularly known as hedge funds. More than 8,900 hedge funds, or private investment companies, managed more than $1.43 trillion in assets as of June 2009.  Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivatives, leverage, fee structures and the liquidity of interests in the fund.  This, along with the performance fee and the fund’s open-ended structure, differentiates a hedge fund from an ordinary investment fund.  Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.

          The 80-20 rule (80% of your business is done by 20% of your customers) is nowhere more apparent than in the hedge fund industry.  The 100-largest hedge funds now control about 70% of the money in the hedge-fund world, up from less than 50% at the end of 2003, according to Morgan Stanley’s prime-brokerage unit, which caters to funds.  300 hedge funds with $1 billion or more control about 85% of all the money in the business.  Based on this author’s analysis of figures from a variety of sources, the remaining 8,800 funds may control on average as little as $45 million each.

          Is this a meritocracy system?  Do the largest fund managers deserve all this money under management?   Are they that much better than the other 8800 funds? Working with Barclay Hedge, we culled the data, built histograms and Pareto charts and concluded that more often than not the top performing hedge fund managers had less than $100 million under management.  These money mavens, often times emerging fund managers, can generate superior performance versus their more established and larger competitors.  But size itself was no predictor of success. There are over 1,800 of these sub $100 million hedge funds out there. They are not all good.  Far from it, you have to do your due diligence.

            People invest in hedge funds to earn a return on capital and to preserve it.  A return on capital is often looked at on a multi-year basis; one, three, and five year returns or longer are standard periods.  Funds that generate returns (alpha[3]) above the benchmark indices with lower than normal volatility (beta) will attract assets.   The Sharpe ratio is commonly used as a measure of that.  The chart from Barclay Hedge provides an overview of these measurements and how the universe of funds has measured up.

          The hedge fund industry primarily grew out of the failings of the mutual fund industry.  Hedge funds differ from mutual fund in that investors provide hedge fund manager with the ability to pursue absolute return strategies.  Mutual funds generally offer only relative return strategies.  An absolute return strategy means that regardless of market conditions, a hedge fund manager will make money.  This differs from what is called a relative return strategy, which is how one fund does against a benchmark.  Unlike mutual funds, which are long only (meaning they are able to make a buy or sell decision), a hedge fund is able to implement more aggressive strategies and put on positions that include short selling.  Managers may also employ derivatives, instruments, such as options, and use leverage to enhance the portfolio and add to the positive performance of the bottom line.

          Hedge funds are also exempt from other requirements that apply to mutual funds for the protection of investors, such as regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, and regulations limiting the use of leverage. These exemptions permit hedge funds to engage in leveraging and other sophisticated investment techniques to a much greater extent, which typically allows them to generate higher returns than other investment vehicles. Of course, like mutual funds, hedge funds are subject to the anti-fraud provisions of U.S. federal securities laws.

          There are a variety of reasons to include hedge funds in a portfolio of otherwise traditional investments. The most cited reason to include them in any portfolio is their ability to reduce risk and add diversification.  Many hedge funds claim absolute return mandates whereby returns are minimally correlated with the equity market. In such a case, hedge funds provide a great diversifier, particularly in times of increased market volatility and/or an outright bear market.

           Risk Reduction-In any case, a hedge fund that provides consistent returns increases the level of portfolio stability when traditional investments are underperforming or, at most, are highly unpredictable. There are many hedge fund strategies that generate attractive returns with fixed-income-like volatility. The difference between a hedge fund and traditional fixed income, however, is that during times of low interest rates, fixed income may provide stable returns, but those are typically very low and may not even keep up with inflation.

          Hedge funds, on the other hand, can use their more flexible mandates and creativity to generate bond-like returns that outpace inflation on a more consistent basis. One drawback is that hedge funds may have certain terms that limit liquidity and are highly opaque. That said, a carefully analyzed hedge fund can be a good way to reduce the risk of a portfolio, but we stress the importance of proper due diligence.

          Return Enhancement- Another primary reason for adding hedge funds to a portfolio is the ability of some hedge funds to enhance the overall returns of a portfolio. This objective can be considered in two ways. The first way is to maintain a low-risk portfolio but to try to squeeze out some additional returns through the use of a low-volatility hedge fund, as described in the previous section. By adding a hedge fund strategy that substitutes for an otherwise anemic fixed-income return, the returns on a portfolio can be increased slightly without any increase in volatility.

          The second way, which is much more exciting, is to add a hedge fund with a high-return strategy to boost overall returns. Some strategies, such as global macro, or commodity trading advisors, can generate some very high returns. These funds generally take directional positions based on their forecast of future prices on stocks, bonds, currencies, and/or commodities and can also invest using derivative instruments. But buyer beware that although these strategies are not correlated to traditional investments, they often exhibit high levels of volatility. The result, when properly allocated, can be a nice boost in returns without a proportional increase in portfolio volatility.

          Allocation Considerations-Adding hedge funds to a portfolio, however, should not be taken lightly. Even a low-volatility hedge fund can explode, as we saw in late 2007, when the subprime mortgage market dried up and even securities that were paying as planned were written down to pennies on the dollar, as investors bid down their prices for fear of foreclosures.
The allocation to hedge funds should consider the overall risk/return objectives of the portfolio, and proper analysis should be conducted to determine how and whether a particular hedge fund fits into the asset mix. A portfolio manager should not only consider the weighting given to any particular investment, but should also evaluate the level of concentration of the overall portfolio, and the correlation of each position relative to each other. For example, in a very concentrated portfolio, it is even more important that each position is less correlated to others, and one must also make sure that positions do not have similar performance drivers.

          Yet another consideration when adding hedge funds to a portfolio is the level of gross and net exposure of the overall portfolio. With traditional investments, for example, gross and net exposure will always be the same and will never exceed 100% unless the portfolio adds its own leverage to its positions. With hedge funds, however, many of them employ leverage and in many cases, their net exposure is influenced by their long and short positions.

          Therefore, a larger allocation to hedge funds will directly affect the total exposures of an entire portfolio. To use a highly leveraged fund as an example, assume a 10% position in a fund that is 10-times levered. If all other portfolio positions maintain a 100% exposure, the addition of a 10-times levered hedge fund will increase the gross exposure of the entire portfolio to 190%. The implications of this change can be dramatic depending on the strategy being used by the hedge fund. 

          Popular Misconception- The popular misconception is that all hedge funds are volatile — that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

          Conclusion–Hedge funds have a definite place in portfolios for both return enhancement and diversification. They do have some drawbacks that should be seriously considered during the portfolio construction process, but carefully selected hedge funds, or even hedge-fund-like strategies, are a great addition to any portfolio.

• There are a huge variety of hedge fund investment styles – many uncorrelated with each other – provides investors with a wide choice of hedge fund strategies to meet their investment objectives.
• Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets — unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.
• Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds.
• Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.

          Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus aligning the manager’s interests and the investor’s.  In addition, hedge fund managers usually have their own money

[1]IRI Study Uncovers how Recession, Age-Driven Lifestyle Changes and Health Issues

are Impacting Baby Boomers

[2] University of Michigan 2009 study is based on data from 4,412 older Americans collected in April and May of this year in a special Internet survey of respondents of the Health and Retirement Study, a nationally representative sample of Americans age 51 and older conducted by the U-M Institute for Social Research (ISR) and funded by the National Institute on Aging.

[3] See Hedge Fund terms in appendix