The Straight Story: Hedge Funds
By: Sam Wiseman
While hedge funds are capturing more and more attention from the investment community, Sam Wiseman, of Wise Capital, is not certain the industry has the resources to adequately assess the vast hedge fund industry.
In an unregulated environment, with so many entering this area, hedge funds have attracted the attention of:
- Pension plan sponsors who need to juice returns as a result of low expectations of returns on fixed income assets
- Individual investors who are attracted by the occasional astonishing return and are increasingly meeting minimum investment qualifications
- The investment community, in general, which needs and wants to understand what is going on
- Consultants who are overwhelmed by the vast number and complexity of this booming industry
- Regulators, seeing high profile funds disappearing, who want to protect the public
Are hedge funds worth the awesome high fees? Can they repeatedly deliver on high performance? Why are they so hard to analyze?
Let us look at new research that is just beginning to give us answers to these questions.
Lack Of Transparency
By their nature, hedge funds lack transparency. This is a critical factor that signals to experienced and knowledgeable participants to beware. The lack of transparency manifests itself when one attempts to standardize performance, risk measurement, or due diligence.
From their point of view, hedge fund managers want to protect their proprietary investment processes. They are not obliged to reveal holdings or even meet with the typical client.
The holdings are audited annually but turn over many times in the year. Commissions are five times that of a prototype long fund and, hence, it is impossible for an outsider to measure the risk. Hedge funds perceive it as in their business interest to appear to be wizards hiding behind the curtain.
This lack of transparency is an advantage in attracting some skillful managers to the industry who do not want consultants looking over their shoulders, telling them that they are changing their style or taking too much risk against the benchmark.
The high fee structure is very attractive to managers and salesmen. A recent study shows that compared to traditional long-only investment management, hedge funds have 10 times the fees at one-fifth the staff. The high incentive bonuses do result in gaining of performance. And that’s why studies reveal that a shoot-thelights- out year of performance can be followed by three years of very plain performance.
To the mainstream investment industry, which is extremely conservative, the challenge of finding and tracking hedge fund managers is proving too great. The quantitative tools available are inadequate to control and manage the risks of hedge funds. The interviewing skills and due diligence cannot, before the fact, consistently detect failing strategies. Efficient frontiers, assumptions of normality, these do not work for a simple reason, these managers are selling short! Traditional investment tools break down because – just as you cannot use a hockey stick in a baseball game – it’s a completely different sport!
The quick answer of Value at Risk (VaR) doesn’t cut it either. VaR assumes log normality, which underestimates the true risk of hedge funds when there is short selling.
When the manager shorts, there is an unlimited downside. When the manager gets his short wrong, his short position increases. He is fighting the natural upward trend of the market. Shorts have a small time horizon and need constant replenishment, and many stocks cannot be practically shorted. Also, there are more market rules to follow and you are fighting management when you sell their stock short.
Few track records go back 10 years. Back tests are particularly unrelated to actual performance, including low correlations shown against conventional benchmarks.
New research shows returns have a 2.43 per cent annual survivorship bias. In longonly equity strategies, that’s the difference between the median manager and the best long-term managers. Total fees, including performance fees, take another five per cent (Ennis and Sebastian, Journal of Portfolio Management, Summer 2003). Over a longer term time frame, the average hedge fund has, at most, a two per cent a year annualized return.
The standard deviation of the hedge fund manager universe is nearly as high as equities. And is the risk reduced by having a group of managers? Research shows five to 10 managers gives you a 75 per cent diversification. However, adding managers often increases risk by adding different market exposures. You are not hedging in a multi-manager program. When the sponsor is investing in long funds, adding additional managers normally covers more of the market and reduces risk.
Furthermore, there is a herd effect with hedge funds making similar bets. For example, recently the herd has been following long gold and oil. Because they are enigmatic, they are often misclassified by managers and potential investors. Hedge fund managers still swim in the same waters as other investment managers. They are not diversifying so much as they are merely applying different and large bets in selected investments. Because of the immense probability of negative surprises, the Sharpe ratio does not measure the skill of hedge funds.
Another principle of finance that cannot be readily applied is that of time as a diversifier. Over a longer period, a disciplined long-only manager will normally achieve his performance objective as risks cancel out. Research shows this is not the situation for hedge funds, largely because of insolvency risk.
Losing all of your money is certainly risky. That’s not simply having a short-term volatility in the strategy. And 10 to 20 per cent of the hedge fund universe goes bust in any given year. Some high profile busts include Long Term Capital Management, Manhattan Capital Management, Maricopa Investment Corporation, and Lipper Convertible Arbitrage. At an AIMR conference in 2003, a well-respected senior portfolio manager forecast that 80 per cent of current hedge funds will disappear within a few years.
Lack Of Due Diligence
To make a difference in traditional risk/return tradeoff analysis, investors need to allocate 20 per cent of their money to hedge funds, studies show. This requires awesome support of consultant knowledge. It’s not available. Perhaps a couple of the very biggest consultants can follow some hedge funds, but, for the most part, consultants simply cannot afford the infrastructure to do a proper job to educate themselves on the many strategies and track the 4,000 managers in any prudent depth.
One bad manager can wipe out all the benefits of a hedge fund allocation. So several managers are required in a program. The search must be diligent as it is an unregulated industry, where few managers are well-known by a reliable analyst. An on-site check, the smell test of sophisticated institutional investors in long funds, only works if the inspector has the knowledge.
The investor must pick several different types of managers, not based on track record. The list of different hedge fund strategies alone can fill a long list. It can even include strategies that rarely short sell. Many of the fund-of-funds limit managers to $200 million in any strategy as an optimal size to be nimble. Some even limit the amount to $20 million.
Institutions are more often dealing with the opportunity to invest in hedge funds by delegating the due diligence to fund of funds. But these managers of managers, despite adding an additional layer of fees, may not be doing significant due diligence. If there are great risks in the industry, they can be compounded by having fund-of-funds.
The first hedge fund model was long/short equity hedge funds. About half of the hedge funds out there can be identified by this description. They tend to invest in equities, both on the long and the short sides, and generally have a small net long exposure. This alone still is more risky than long-only.
They are genuinely opportunistic strategies capitalizing on stock picking skill. A subset of that is ‘market neutral hedge funds’ that seek to neutralize certain market risks by taking offsetting long and short positions in instruments with actual or theoretical relationships. These are essentially long/short equity hedge funds that maintain long and short portfolios of the same size and/or risk. It is nearly impossible to be 100 per cent market neutral in every period. There is no tool kit or model available to offset all risks, so that it is a long/short strategy, but it is only a question of degree of the magnitude of the long direction.
Sam Wiseman is chief investment officer at Wise Capital Management.
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