Class asset
April 2008
Olivier Rouget reviews the role hedge funds can play in asset allocation practice...
The ultimate objective of most trustees is to invest the charitable funds so that the charity can carry out its purpose in perpetuity. Modern finance theory is the key to achieving this goal. One of its main components is asset allocation and the Holy Grail of modern finance, according to the theory, is to identify uncorrelated asset classes with various risk/return profiles. Allocating between these various asset classes will increase the overall return of the portfolio and lower its risk (volatility) making it more efficient. Hedge funds are a relatively new asset class that offer this flexibility.
‘Hedge fund’ has become a very vague term to the point of becoming almost useless. But for the purpose of this article we will define a hedge fund as an unregulated investment scheme investing in relatively liquid financial assets with a great degree of freedom in order to achieve absolute returns. Absolute returns are not dependent on the core market (equity, bonds, commodities) returns which means that the hedge fund managers are aiming at making money, in theory, in all market conditions
A homogeneous group of uncorrelated hedge funds delivering absolute returns indeed constitutes a powerful asset class which is why hedge funds have been an indisputable growing success and are becoming impossible to ignore for any professional investor. But the big question is how do they do it?
How hedge funds delivery absolute returns
To put it in simple terms, hedge funds use a subset of a couple of dozen strategies which have been broadly arranged in four ‘families’. Each has its own risk/return and correlation characteristics:
- The ‘relative value’ family, which encompasses most arbitrage strategies such as convertible arbitrage, fixed income arbitrage, capital structure arbitrage, statistical arbitrage etc. The general idea is to exploit inefficiencies of the markets. Because these inefficiencies are rather small, these strategies often use leverage to magnify the returns.
- The ‘event driven’ family, which comprises strategies linked to specific market situations such as mergers or acquisitions of companies or management changes. The notorious activist managers not only bet on certain outcomes but actively push for these outcomes to actually happen.
- The ‘equity long-short’ family. These strategies are perhaps the simplest to understand and illustrate well, the spirit of what most hedge funds are trying to do. By buying shares of an undervalued company and simultaneously shorting shares of an overvalued company in the same sector, one could make money regardless of the overall change in valuation of the entire sector.
- The ‘tactical trading’ family. These strategies are actually relying more on market calls and rely on the skills of the managers to make money betting on equities, bonds, currencies and commodities.
All of these strategies are well known and well understood but making money consistently still requires a great deal of talent, resources and hard work. Out of 10,000 to 15,000 hedge funds managing 1.2 to 1.5 trillion dollars, only a fraction will meet the criteria of the savviest investors.
How to invest in hedge funds
In our experience – for investors with limited resources dedicated to the field – the best way is to start by investing in ‘funds of hedge funds’.
A fund of hedge funds offers three important benefits:
- Access to the best hedge fund managers. These are something of a rare breed and are difficult to identify as many of them provide very limited or no information to the general public. Also, hedge fund managers typically use unregulated investment vehicles to give them the flexibility of investment that they need. Therefore a thorough due diligence on the entire structure of the fund – as opposed to just the track record - is essential before investing, which remains difficult to achieve for the general public. Finally, good managers will not put their returns at risk by taking on too many assets and will close their funds to new investors. In such cases, it is easier for a fund of hedge funds to negotiate additional capacity directly with the hedge fund managers than for individual investors.
- Diversification. Given the high dispersion of returns and the fact that hedge funds are unregulated investment schemes, it is critical to be well diversified. A typical fund of hedge funds is composed of 30 to 60 underlying hedge funds, which ensures that the portfolio is sufficiently diversified amongst strategies and managers.
- Liquidity. A fund of hedge funds also acts as a liquidity provider due to the fact that each underlying hedge fund manager typically has a high minimum investment (1 million USD and above) and tends to have lock-up periods that may vary from a few months to several years. By investing in a fund of hedge funds, the investors might invest a smaller minimum investment and benefit from a monthly or quarterly liquidity.
Selecting a good fund of hedge funds is a matter of ensuring that the fund has a proven superior track record, a demonstrable access to the best funds in the world, a demonstrable diversification and a decent liquidity. In addition, the interests of the fund of hedge funds manager and that of the investors should be closely aligned to create a successful long-term relationship. This is indeed the best way to become more knowledgeable about the investment.
How much to invest in hedge funds
There is no definitive answer but the following factors should be considered:
- Liquidity and income needs. Funds of hedge funds typically have a quarterly liquidity and do not yield any income. They are therefore inappropriate for short-term funding needs. Like equities or real estate, hedge funds should be given the benefit of an intermediate to perpetual time horizon and in that sense they are particularly appropriate for charities and endowments.
- Strategic asset allocation. If we stick to our initial definition of hedge funds as a diversified uncorrelated asset class, hedge funds should be at the minimum on par with equities, private equity, real estate and commodities and should constitute a core holding of any portfolio. Bonds and cash will not protect the portfolio against inflation over the long term and should be considered for the sole purpose of meeting the short to medium term liquidity needs.
It is no coincidence if the most spectacular returns over the long term have been achieved by American university endowments such as Yale, Princeton or Harvard using these asset classes. The 2008 Yale endowment asset allocation target for hedge funds is 23 per cent of the total portfolio and has not significantly changed in the last 10 years.
When to invest in hedge funds
If past performance is any guide, there is no good or bad entry point into the hedge funds asset class due to its absolute return characteristics. Hedge funds had positive returns during the last serious bear market for equities in 2000 to 2002 and there is no objective reason to think that this will be different in the future. 2007 was interesting in this regard. Most funds of hedge funds delivered high single digit or low double digit returns, significantly outperforming most equity and bond markets. One salient point in 2007 was a very high dispersion of returns among single hedge fund managers, particularly in the credit area where a handful of managers lost most of their capital by investing in US sub-prime mortgages, and another handful of hedge fund managers achieved spectacular returns by taking essentially the opposite view.
In principle, there is nothing wrong with a high dispersion of returns but it does highlight the necessity for first time investors to be well diversified and to invest in funds of hedge funds rather than a few single hedge fund managers. 2008 is off to a bad start for equities and while hedge funds too have had a negative performance, they have again outperformed equities over this short period.
Of course, the goal is to achieve reasonable positive returns in the remainder of the year and we see that goal as attainable. Indeed, a return to higher market volatility is beneficial to a number of hedge funds strategies and a lack of liquidity or dislocation in some credit markets, sometimes due to the withdrawal of banks, will give rise to exceptional opportunities for nimble and smart hedge funds buyers.
An asset class not to be ignored
We find that it is beneficial for charities to invest in hedge funds and believe that the inflow of money into hedge funds will continue to grow rapidly over the coming years. Indeed, many institutional investors have invested around 2 to 3 per cent of their portfolio to start with and will certainly increase this allocation significantly over time. In fact we believe that it is a riskier choice for any investor to ignore this asset class.
As with any other investment, it is crucial that each investor understands the underlying hedge fund strategies before making significant commitments. To do so, first time investors should select a couple of fund of hedge funds and build their knowledge of this asset class.
Author: Olivier Rouget
Olivier Rouget is a managing director and co-founder of Nevastar Finance Ltd. Previously; he spent 15 years as an Executive Director in the investment Management Division of Golman Sachs. Olivier holds an MBA from the Wharton School of the University of Pennsylvania and a degree in Economics from the University of Geneva
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