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Hedge funds
For further information, please contact Danny Wilding at the London office.
It is increasingly common currently for investment strategy discussions to include hedge funds. However, the nature of these funds and their appropriateness for different investors are not widely appreciated. This note aims to introduce some of the key principles that investors such as pension fund trustees should be aware of.
What are hedge funds?
The term is applied in practice to a wide variety of different funds following "alternative" investment strategies. We describe two of the most common, and perhaps most important, types of hedge fund strategy below under the headings "long-short strategies" and "fixed return strategies".
Long-short strategies
A conventional active equity manager usually seeks to generate out-performance (relative to the market as a whole, as measured by an appropriate index) by choosing to invest only in those companies he expects to out-perform, and avoiding those he does not. In comparison, a long-short manager typically seeks to add value in four different ways:
- The manager still chooses to buy his favourite stocks (referred to as being "long" in a stock). However, the main difference with a traditional manager is that the hedge fund manager is more likely to concentrate the portfolio in a smaller number of preferred stocks, rather than seeking to maintain any particular level of diversity.
- Rather than simply avoiding the stocks he dislikes, a hedge fund manager actively seeks to borrow such stocks from long-term investors in order that they may be sold on (called being "short" in these stocks).
- The hedge fund manager would typically borrow against the fund and therefore invest in the market well in excess of 100% of the fund value (known as "leverage").
- The fund will often invest in derivative options, on a rolling basis, that relate to movements of a market as a whole. An example would be an option that pays out in the event that the equity market suffers a set back (known as a "hedge").
These techniques (if used skilfully) can enable the hedge fund manager to avoid the full impact of market falls. However, because only part of the fund is invested directly in the market, the hedge fund may be less likely to capture the whole of the return when markets are rising. This means that you might expect long-short hedge funds to perform particularly well when markets fall, but perhaps less well when markets are rising.
Fixed return strategies
Many hedge funds are not targeted at particular markets but work on the principle that if they can generate a fixed return, of perhaps 1% a month month-in-month-out, then over time this is likely to represent an attractive return compared to other asset classes (especially compared to bonds or cash). A hedge fund manager normally seeks to achieve this by investing in a range of opportunistic projects.
This may include arbitrage, where the manager identifies inefficient market pricing (for example if a share could be bought in dollars and sold in sterling at a profit due to a temporary mismatch from the pound/dollar exchange rate). Another example is speculative merger arbitrage, where a share is purchased in anticipation that the price will increase in the light of an impending corporate merger.
Not every speculative project will pay off, and the hedge fund manager tries to invest in a sufficiently wide range of projects that he expects to win overall even if some individual projects fail.
What are the potential benefits of hedge funds?
The long-short managers aim to outperform traditional equity managers. The main reason that hedge funds are such a topical issue is that over recent years there has been some quite spectacular outperformance from certain funds. At least in part this is due to the beneficial effect of a "hedge" strategy during periods when markets are falling. The effect of this can be to generate positive returns whilst most traditional managers suffer negative returns in line with the market as a whole.
At the same time, with cash and bond yields at relatively low levels, the returns generated by fixed return hedge fund managers have also outperformed these asset categories over recent years.
Although many hedge funds do not have a long track record, there is also evidence that many funds enjoy relatively low volatility of returns in absolute terms. The long-short managers might be seen to deliver a "smoothed" equity return whilst fixed return managers tend to demonstrate less variation in year-on-year performance than bonds.
Who are the hedge funds managers?
There are several thousand individual managers operating hedge fund strategies of one kind or another. Typically exposure is obtained through a "manager of managers" whose job is to research the market and maintain a preferred provider list of individual managers with whom funds are placed. The number of underlying managers used may vary, depending on the confidence that the manager of managers has in their own screening process.
Some of the large traditional investment houses have a hedge fund service (or are considering this area). However, given the specialist nature of hedge funds some may choose to contract out this business to established hedge fund managers of managers.
The total global hedge fund marketplace now amounts to around 500 billion US dollars.
What are the risks?
The risks of hedge fund investment are complicated. Perhaps the greatest barrier to hedge fund investment currently is gaining a sufficient understanding of the quantity and nature of the investment risk involved.
It may be expected that occasionally individual managers will default, either through poor decision-making or fraudulent action. All money invested with a defaulting manager may be lost. Clearly, it is therefore important to diversify hedge funds across as many underlying managers as possible. It is also critical to have confidence in the screening process of the managers of managers to minimise this risk.
There is also a risk of underperformance. Long-short funds may not beat traditionally equity management in future (perhaps during periods of sustained market growth in particular). Fixed return managers may gradually run out of opportunities, due to increased market efficiency or market saturation.
Indeed there are examples of large losses, such as the collapse of Long Term Capital Management in 1998.
Investment management fees may also be expected to be relatively high for hedge funds. It is normal for performance-related fee scales to apply, so that charges should only be high when good cumulative performance has been achieved. This slightly reduces the problem but gives to the manager some of the reward for which the investor has paid a risk premium.
Finally, hedge funds are often relatively illiquid, as funds are tied up in particular projects or positions at any one time. Requiring a hedge fund manager to disinvest at a particular time may mean that full advantage can not be taken from some of the particular investment positions adopted, so performance may be diminished. Disinvestment from hedge funds may therefore require a few months notice.
What are the particular considerations for pension scheme investors?
Trustees should be aware that the hedge fund market is largely unregulated. In particular this may mean that the quality of reporting is sometimes poor and the measurement of performance sometimes unreliable.
Another concern may be that custodial arrangements for hedge funds could be more remote than for traditional investment arrangements. (If the trustees give money to their investment manager who gives it to a manager of managers who gives it to an individual hedge fund manager who gives it to a third party investor as collateral for borrowing a stock which he then sells to a fourth party, then who should hold the share certificate?)
Many pension schemes would prefer to have a longer track record of performance than is available for most hedge funds. For example, attribution of long-short fund performance between the different strategy components mentioned above may require more data than is currently available. It may also be difficult to determine an appropriate benchmark against which to measure performance, given the unusual nature of the investment strategies adopted.
Most individual hedge fund managers only have a limited capacity. For example, only a certain amount can be invested in a particular price anomaly arbitrage before market forces dictate that the anomaly disappears. If all UK pension funds were to simultaneously invest more than a very small proportion of their assets into hedge funds then demand for particular managers could exceed capacity.
The rules of many pension schemes may prohibit leverage and/or borrowing shares and selling them on. A change to the rules may therefore be required before hedge fund investment could be considered, and trustees would have to satisfy themselves that this would be appropriate.
Finally, pension funds must remember that their liabilities are not fixed in monetary terms. Hedge funds returns are "despite the markets", rather than a reflection of the return of particular markets. However, arguably the value of long-term pension commitments should reflect long-term interest rates, in a similar way to the value of long-dated bonds. Investment volatility therefore needs to be considered relative to market interest rates rather than just in absolute terms. In other words, returns that look smooth to a short-term investor may in fact appear volatile to a long-term investor such as a pension scheme.
This is particularly true of statutory liabilities for the Minimum Funding Requirement (MFR) and the new Accounting Standard (FRS17). Hedge fund investment may lead to more volatile funding positions against such statutory standards.
Conclusion
In our view there is much to be understood before investors, especially pension scheme trustees, should consider hedge funds.
For those who wish to investigate this subject further, we would be happy to undertake further research on request and we would also recommend discussions with existing investment managers on this subject.
For specific advice on pension investment issues please speak to your usual Barnett Waddingham contact.
Danny Wilding, September 2001.