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Balancing Act

All the traditional asset classes, such as equities and property, in which pension funds invest, share an underlying flaw: the investor can only profit when asset values increase. As we have seen over the last couple of years, this is far from guaranteed.

Every asset poses two forms of risk. The first is the risk specific to that asset, for example, an equity contains the risk of the company’s management making a mistake that leads to the share price falling. The second form of risk is that the whole market falls, perhaps due to some broader shock to the economy such as the credit crunch.

This is where hedge funds come in. Depending on the choice of hedge fund strategy, hedge funds can profit from relative movements in asset prices and isolate themselves from market crashes. For example, for an arbitrage strategy, a fund manager could buy shares or go long in one company and sell, or go short, shares in another (which it has typically borrowed from another investor). This means that the fund is unaffected by the general direction of the markets and gains or loses only by the skill of the manager in selecting such pairs of companies.

Too Good to Be True?

The holy grail of investment is producing equity-like returns for bond-like risk – something that is often promised and rarely delivered. Can it really be true in the case of hedge funds? The answer depends on how much risk you consider hedge funds pose. The general, somewhat negative, perception of hedge funds does not entirely fit with reality. Public perception has been coloured by the complexity and opaqueness of the investment strategies and a few startling scandals rather than the returns they have produced over time.

During the credit crunch and particularly during the dot-com bust in the early years of this century, those returns and hedge funds’ limited volatility were relatively successful. For a hedge fund to be successful in all market conditions, it needs to genuinely reduce risk.

Several hedge funds imploded during the financial crisis because it emerged that, in reality, they were predominantly long-only funds (ie mostly invested in traditional equities) that were using debt to boost returns and were not managing risk half as expertly as they appeared to be. It is easy to make money in a bull market by using debt rather than skill – we only know which ones have skill in a bear market.

Fund of Hedge Funds

Choosing a manager is a challenging task. How can trustees perform due diligence on managers when their strategies are opaque, at best, and sometimes downright secretive? Plenty of experienced investors were caught up in the Bernard Madoff scandal, for example. Trustees can draw on the experience of their investment consultant and investigate the market themselves. But they may also opt to pay for a layer of expert management.

A fund of hedge funds refers to an investment fund that invests in a selection of hedge funds. This has two benefits. Firstly, because the investment is spread across several funds, the risk of substantial losses due to a problem in any particular fund is reduced. The second benefit is that the fund of hedge funds manager should be an expert in the industry and be more likely to pick successful hedge funds.

The price of that arrangement is, well, the cost. Such expert knowledge must be paid for and results in an additional layer of fees. This may be partly offset by the discounts that fund of hedge fund managers can obtain from hedge funds, because they are investing on behalf of multiple investors. Nonetheless, fees are a critical issue and trustees need to be satisfied that they are securing value for money.

Inside a Hedge Fund

Hedge funds can be grouped into several categories. Trustees need to understand exactly what they are invested in and how that fits into their broader portfolio. For example, a hedge fund that predominantly invests in equities will not provide much diversification from traditional equity funds.

Hedge funds have several shared characteristics.

  • The managers often invest in their own funds.
  • Hedge funds have the ability to take short positions and have strategies that are surrounded in secrecy – although after the challenges of the last couple of years, they have become more transparent.
  • The way performance is measured is different to equity funds. As there is no underlying benchmark – such as the FTSE 100 – hedge funds target an absolute return such as 5% profit per year.
  • There are typically time constraints on investing and de-investing from a fund. During the financial crisis, many hedge funds increased these restrictions to prevent investors from withdrawing large amounts of money that could have resulted in the collapse of the fund.
  • Hedge funds are only loosely regulated at the moment. However, this may well change in the near future – proposals are currently being circulated at the European Union level and the United States also looks set to act.

There are two overarching classifications of hedge funds:

Directional strategies

This group, also known as equity risk strategies, includes funds described as long/short equity, dedicated short, global macro and distressed debt funds. Such funds are likely to have some correlation with equity markets and so trustees should consider how well they combine with existing investments.

Example: Global macro funds have enormous flexibility in their choice of investment options. They can take long or short positions in equities and can speculate in credit and currency markets, taking bets where broader economic analysis suggests that certain assets are under or overpriced.

Non-directional strategies

These strategies, also known as alternative beta strategies, attempt to gain by arbitrage or relative value of assets in the market. The idea is that the manager identifies pairs of assets where gains in one offset losses in another. Returns should not be correlated with the rise and fall of the equity market. The problem is that such correlations could break down in a crisis – just when they are needed most – so funds are high risk.

Example: Statistical arbitrage involves extensive use of data mining and computerised statistical analysis to identify investment opportunities. The fund manager sets a computer strategy to purchase assets that he or she considers to be under or overpriced, normally by a tiny amount and possible only for a matter of seconds, according to historical data.

Arbitrage strategies have been described as being akin to “picking up nickels in front of a streamroller”. That is, they provide a stream of small profits but leave the investor vulnerable to one cataclysmic event that could completely wipe out the fund.

This article first appeared in on 24 March 2010.