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The Actuary The magazine of the Institute & Faculty of Actuaries

Why invest in hedge funds?

Institutional portfolios have, for many years, concentrated their investment portfolios in UK or overseas bonds, equities, and property. Equities have historically provided the greatest returns, but are usually associated with the greatest risk and volatility of performance. Alternative forms of investment have always been sought, but where good returns have been on offer, they are often combined with high risk levels and poor liquidity. However, the growth of absolute return funds (hedge funds) allows institutional investors the opportunity to combine excellent returns with low risk and good liquidity.
A total return fund, commonly known as a hedge fund, is an investment fund unrestricted in the range of investment styles, instruments, or strategies that it employs with the target of producing absolute or total returns.
The use of a wide range of strategies, the availability of an unlimited variety of instruments and varying amounts of leverage, which are often outside the remit of many conventional investment managers, allows the hedge fund to perform equally well in both rising and falling market conditions. Hedge funds historically provide high returns, often with low volatility of performance and very low correlation of return with conventional investment funds or indeed other hedge funds.
The growth of hedge fund investment worldwide is significant, with an estimated $6.9bn of net new money being invested in the first quarter of 2001, almost as much as the whole of the previous year. Estimates for the growth of hedge funds in Europe are also significant, with funds under management expected to almost double during the year, from $45bn at the end of 2000.

A hedge fund is usually open-ended, although occasionally closes for new money, as a result of capacity constraints. It admits capital and allows redemptions periodically, normally monthly.
The fund and its management company are usually based offshore, although the investment advisers are usually located in or near a major financial centre, where the fund manager actually conducts the trading.
The fees typically charged by hedge funds are usually in two forms: an annual management fee and a performance fee, based upon results. The overall performance of hedge funds is usually quoted net of all fees.

Trading strategies
Given the wide range of available and permissible market instruments, the ability to use derivatives, and the advantages of leverage, there are many types of trading strategy available to the hedge fund manager. Some hedge funds limit their trading to one particular trading strategy, others combine a number of trading strategies. Whichever the case may be, the trading strategies can be generally categorised as follows.

– Market-neutral These strategies exploit the relative values between different but related securities. Strategies are designed to be market neutral and hence broadly insulated from general market direction and volatility, eg fixed-income arbitrage, equity market-neutral funds.

– Event driven This strategy attempts to capture one-off events such as a merger, an acquisition, or a corporate reconstruction. The strategy would also be market-neutral and thrives at times of high levels of corporate activity, eg merger arbitrage.

– Long/short This strategy allows the manager to take either long or short positions in securities, either fixed-income or equities. Market exposure may not necessarily be reduced and volatility of earnings can be as high as that of conventional fund managers. However, the strategy allows good performance, regardless of underlying market direction. Correlation with conventional fund managers is usually somewhat higher than other hedge funds, particularly in rising stockmarkets.

– Tactical trading This category uses long and short positions across a number of markets and economies to gain directional exposure. A wide range of asset classes is traded, including equities, bonds, currencies, and commodities. Volatility of earnings can be high for individual funds but, importantly, there is little correlation with conventional fund managers and other hedge funds, eg global macro, emerging markets, and distressed debt funds.

Investment attractions
There are many empirical and fundamental reasons in favour of including hedge funds in an institutional investment portfolio, and the major ones are:

– High returns and low volatility History has proved that the returns offered by hedge funds are similar to those produced by the major equity indices, while the risk, measured by the volatility of earnings, is closer to that expected from bond investment.

– Low correlation One of the disadvantages of conventional fund management is the very high correlation of performance between funds. This means that in poor investment conditions all fund managers perform poorly, with the target merely to outperform the opposition rather than providing an absolute return for the investor. This high correlation means that there is not so much to choose between fund managers. Hedge funds exhibit precious little correlation between each other and with conventional investment funds. Hence they can perform well in all market conditions, irrespective of the performance of conventional funds.

– Variation of risks The investment risks involved within a hedge fund are different from those encountered within the conventional market. The conventional fund manager brings the risk of falling markets; the size of this risk depends on the individual manager, but the risk is the same nevertheless. The hedge fund manager may bring this risk, to a certain extent, but it is greatly reduced, as he or she is not confined only to positive market exposure. The hedge fund manager brings greater risk of relative value, enhanced by the level of leverage taken. The necessity of having to rely on greater prediction of market direction, stock selection and relative value makes the job of the hedge fund manager more difficult.

– More flexibility It should be of little surprise that the expected returns from a hedge fund should be better than for a conventional fund manager, given the same amount of risk taken. Simply, the conventional fund manager is confined to being long of the market with little use of derivatives and leverage allowed. The conventional fund manager would not expect to perform as well as a hedge fund manager of similar quality who is not similarly constrained.

– Top quality managers As the skills involved in being a successful hedge fund manager are often considered greater than those needed by conventional fund managers, the rewards to attract the most talented individuals are often great.

– Managers’ personal interest Unlike the conventional fund management industry, hedge fund managers are encouraged to have an amount of their own money invested in the funds they are managing. This is analogous to a bank that will not lend money to an entrepreneur unless the entrepreneur has a certain amount of their own capital tied up in the enterprise. Similarly, a hedge fund manager with cash involved in the fund has an increased incentive to perform well.

Fee structure
At first sight, the thought of paying an annual management fee of between 1% and 2% and a performance fee of up to 20% seems excessive, although it should be seen in a different light when considered with the fund’s hurdle rate and high watermark.
The hurdle rate is that amount chosen by the fund manager that triggers the payment of the performance fee. For most hedge funds, performance fees are only payable for that performance over and above the hurdle rate, which is typically selected as a risk-free rate, often the return on money-market instruments.
The high watermark fixes the level that an individual fund has reached when a performance-related fee was last paid. New performance fees can only now be paid for that amount above this watermark, no matter the time of entry into the fund.

Advantages of a fund of funds
In the same way that a unit trust or mutual fund spreads the risks and volatility of earnings of an equity portfolio, a fund of funds invests in a number of carefully selected hedge funds, spreading the risks and reducing the problems of selecting any one, poorly performing fund.
As the correlation of performance between hedge funds is very low, spreading the investment between a variety of hedge funds reduces the volatility of earnings dramatically, providing very low risk while enjoying a performance equalling the average of the funds invested. In funds of funds, the maximum drawdown (the largest fall from high market valuations) is usually much lower that traditional forms of investment.
It is thought, therefore, that funds of funds are ideal vehicles for investors who would like to reduce their volatility of returns. Moreover, the fund of funds provides greater capacity and liquidity than investment in individual hedge funds and solves the problem for investors unfamiliar with the special skills needed to make the selection of hedge fund managers themselves.

Fund selection and analysis
Understanding the investment strategy of individual hedge funds is a highly skilled job and it is particularly difficult to separate the talented hedge fund manager from a less talented competitor. The qualitative review of managers is probably more important than the quantitative when making this judgement. Only individual one-to-one interviews can really separate the good from the bad. In order to make a successful assessment, the analyst should be able to understand not only the jargon of the markets but the intricacies of the markets themselves. This skill is relatively rare, but the best fund of fund managers will have the experience and expertise to provide this.
But how does an investor discover which of the many established and newly formed fund of fund providers possesses these skills? Most investors will have inadequate experience or market knowledge to make the correct judgement unaided; thankfully, there are specialist companies who will assist in this process.