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The Actuary The magazine of the Institute & Faculty of Actuaries

Classifying hedge funds

Most misconceptions regarding institutional investment in hedge funds result from attempts to bracket them as investment vehicles along the same lines as long-only (conventional) fund managers. It is far more appropriate to consider them as operational businesses, much like any business in which to invest, except that they operate in a different sector of the economy: capital markets.
Of course it is tempting to compare hedge funds with long-only fund managers because of the crossover in some of the instruments they use in the normal course of business, and because hedge funds also seek to attract third-party funds to manage. However, this comparison might lead us to think of hedge funds as investors which can also short the market, rather than managers of market exposures, which is in fact nearer the truth and far more accurate. Moreover, hedge funds use more instruments, trade different strategies, and have different performance and risk targets, so such comparison results in misleading conclusions.

Absolute returns
When making an investment in any company, investors buy into the skill set of the management team of that company. They rely on the company’s management to understand the particular marketplace in which it operates, and to make as much profit as possible out of the capital at its disposal within certain risk parameters. The company often raises money, perhaps on a stock exchange, to increase its capital base in order to enhance earnings. In effect, the company can be described as an absolute return fund as it just targets to make the best profits possible as a return from shareholders’ funds.
This is, in practice, just like a hedge fund where the skills of the managers are also required to make the best absolute return possible from the capital available, often raising this capital from sources similar to those accessed by conventional companies in other sectors. So economically, providing capital for a hedge fund is not so different from providing capital for any other business in the wider field of commerce, except that the sector of the economy within which it operates, namely capital markets, is different from traditional sectors.
Long-only managers do buy the equity of companies for their long-term performance, but they do not expect that the market valuation of the company will always show positive returns because the shares are not valued against their net asset values. Whereas the company itself may target an absolute return, the method of market valuation (valuation overlay) of the share price brings in other variables (which are common across sectors) including economic conditions, inflation and long-term interest rates, and investment sentiment, which prevent equity market valuations from being considered as an absolute return.

Growth in the real economy
Investors have argued that over the long term, equities purchased in long-only portfolios match real liabilities as they grow with economic activity. This is why such a large proportion of pension fund assets are invested in equities and other real assets such as property and inflation-linked bonds.
It has also been argued that hedge fund growth is not linked to the real economy and therefore is not a match for real (or inflation-adjusted) economic liabilities as the growth in performance is not related to real economic issues.
However, the growth in both the numbers of hedge funds and their profitability does actually rely on the growth of the real economy. As the economy grows, so will the capital markets, probably in an accelerated fashion. As the capital markets grow, there will be more instruments and exposures that will make up the marketplace and the opportunities for hedge fund managers will increase.
If matching real liabilities with real assets is so important, why then do non-mature defined benefit schemes hold fixed coupon bonds? Surely, it is because of the prospect of good gains or the undoubted risk reduction that diversification brings. This alone would be a reason for investing in hedge funds, even if the investor is not taken by the growth in the real economy argument above.
So there are similarities between hedge funds and equities. But, as we shall see, many of the voiced concerns about hedge funds still arise from comparing them with long-only managers.

Management fees
Comparison is often made between the management fees of hedge funds and those of long-only managers, the former being significantly higher. This is the wrong comparison to make. It would be more reasonable to compare these management fees with the operating expenses of other operational businesses, where the running costs would typically be a much higher percentage of generated earnings than for hedge funds.
Opaqueness and regulation
Investors broadly understand the sectors that most operational businesses work in and they generally appreciate how profits are made. However, the micro-functions of these companies are often opaque, perhaps not so different from a typical hedge fund. This is why companies employ auditors to understand the business better and to report on matters of concern. However, this does not always work well (too many examples to mention) and is, in any case, a retrospective inspection. While the capital markets are not well understood by a wide range of investors, professional advisors, and institutional investors should understand them sufficiently well to be comfortable and satisfied.

Capacity constraints
It is often argued that the more money that chases hedge funds, the poorer will be their performance as capacity will be limited, but that this argument does not apply to equity or other asset-based markets.
Again we may be making the wrong comparisons. Even if this argument were true, the worst we should assume is that the annualised rate of return of hedge funds might shrink with more inward investment. Surely this is not as bad as a wall of money chasing other asset classes and causing them to become overvalued. That scenario, if we didn’t already know, can cause substantial losses of asset values with the associated pain that it brings. Drawdowns, the maximum loss derived from buying an investment at the peak and selling at the trough, have traditionally been substantially lower for a portfolio of hedge funds than for other asset classes because hedge funds are valued at net asset value and not some discounted flow of future profits.

Risk factors
No institutional investor, however, much he or she likes any one particular investment, would wish to give it too much exposure. The virtues of diversification are too well appreciated. However, portfolios of equities are not sufficiently diverse the correlation of their performance is still far too high. This is not necessarily because the profit flows of constituent companies are correlated, but because the market valuation overlays of most equities are similar across sectors.
The valuation of hedge funds at their net asset value takes away the commonality of the valuation criteria and therefore reduces investors’ exposure to these factors. If equities were valued on their net asset value, like hedge funds, the correlation of performance and the debilitating effects of large drawdowns would be very much reduced, towards the low levels of hedge funds.

Partners’ personal interest
Hedge fund managers often have a great deal of their own personal wealth tied up in the business, unlike conventional long-only fund managers, but similar to the operational businesses in which they invest. A bank wouldn’t lend to a prospective borrower if he did not show his own financial commitment to the business venture. Hedge fund investors should gain similar comfort when there is alignment of interests between hedge fund managers and investors as a result of partners’ personal financial involvement.

Is any comparison fair?
A fund of hedge funds is an investment management company, which uses its expertise to construct portfolios of hedge funds. Comparisons between conventional (long-only) managers and fund of hedge fund managers make more sense than comparing them with individual hedge funds.
Both are indeed long-only, both seek external funds to manage, and both provide research to enhance their investment management business. Both charge fees for their services, but those associated with funds of funds are higher. Is this reasonable?
The conventional long-only manager can obtain readily available information on the companies in which he invests, much of which is freely provided by investment banks, brokers, and the press. A fund of fund manager also has to conduct research and due diligence, but in a more specialised field and without the same assistance.
Generally speaking, typical conventional managers have very similar performances and volatility of results. This is because they tend to match their performance against market indices and so the variance of performance between them is not particularly great. Funds of hedge funds, on the other hand, vary substantially in their investment returns and volatility targets, while adjusting their market beta by carefully balancing their portfolios. The diversity of performance between them is much greater, so basing a greater percentage of their fees on performance and less as a fixed cost, is much more appropriate.
Like hedge funds themselves, it is also common that the funds of hedge fund managers benefit from partners’ own financial interest in them, offering a better alignment of interest.
I leave readers to make their own conclusions from the above comments, but would suggest the following:
n Hedge funds should be compared with the operational companies purchased by conventional fund managers and not with those conventional managers themselves. The major difference is that hedge funds are valued by net asset value and not by some present value of possible future earnings, which itself is risky;
– Hedge funds could be considered in equity portfolios in a separate sector called capital markets, hedge funds or just financials; and
n Funds of hedge funds are more comparable with conventional fund managers and, because of their specialist functions, justify performance-related fees.