Are hedge funds right for you?

Recent research by Barron’s (see Hedge funds head south) suggests hedge funds this year look like they are not going to deliver anything like expected returns. Separately, backed by a wide ranging report from the well regarded Nomura research department , the stockbroker’s managing director Michael Harris said earlier this month: “There is no evidence that alterative assets as a group, outperform passive benchmarks (i.e. the ASX 200) when it comes to diversification or returns."

So should investors steer clear of such alternative assets altogether? The answer to this is no, but only if you can overcome the following obstacles:

There exist dozens, if not hundreds, of different strategies.

Lumping all hedge funds into one big basket is problematic, as there are almost as many strategies as there are managers. Some of the more popular ones include takeover arbitrage (betting on increased bids), risk arbitrage (betting on other events, e.g. interest rate changes), convertible arbitrage (identifying price discrepancies between different securities offered by the same company), index arbitrage (exploiting gaps between physical stock indices and associated futures contracts), and so on. Investment into any of these categories requires a reasonable level of expertise on behalf of the investor.

The quality of manager varies hugely

Let’s say you like the idea of takeover arbitrage (a strategy I’ve traded for 18 years). There are many managers, both local and overseas, who claim expertise in this sector. How do you separate the good from the not so good? Obviously track record over a number of years is an important starting point. Volatility of returns is also worthy of examination. But qualitative issues like the separation of trading from reporting, and the existence of built-in risk controls like stop losses, are also vital in the assessment of any manager. Most of the best fund-of-funds (who place money with individual hedge fund managers) make several site visits and interview all key staff before making any allocations. The presence of well-known fund-of-funds on a hedge manager’s client list is a worthy stamp of approval.

Too much money under management can hurt returns

When hedge funds first open their doors, they often have only a small amount of money to invest. This enables them to be nimble in the market, and to enter and exit profitable situations without impacting prices.

Once a decent track record is established, however, hedge funds typically market their products more widely and if they’re lucky attract larger sums to invest. Unfortunately, while the increased FUM (Funds Under Management) is great for the business owners, returns can suffer as the aforementioned market nimbleness disappears. Some fund-of-fund managers I know say the peak time in a hedge fund’s life is between three and six years, after which complacency can develop.

Not all strategies work all of the time

Different alternative investment strategies work well at different times. The aforementioned takeover arbitrage sector, in which I’m experienced, obviously requires plenty of merger activity to provide suitable opportunities. Until six months ago the Australian market had a two-year drought of corporate activity, which kept people like me sidelined.

The same is true for managers who trade interest rate movements. Central banks like Australia’s Reserve Bank, which keep official rates steady for long periods, can make the hedge fund business difficult.

Investors into any hedge product need to have a clear idea of which market conditions best suit the strategy or strategies they choose.

Style drift can come as a huge shock

When managers find their traditional trading areas have dried up, they sometimes go looking for new and ‘interesting’ opportunities. This is known as ‘style drift’ and is to be avoided by investors at all costs. Most hedge funds have experience in a couple of niche areas, which at times they can exploit well. Straying into other parts of the market usually means coming up against more experienced players and therefore losing money. Good alternative managers stick to their knitting.

Fees can be a killer

For a long time hedge funds got away with charging clients fees based on the ‘two-and-twenty’ structure. This meant an annual management fee of 2%, plus a performance bonus of 20% in positive years. To put these numbers into perspective, most long-only index hugging funds charge no more than 0.4% to 0.8% of FUM.

When alternative managers generate annual returns of 15% or better, the two-and-twenty fees appear bearable to investors. After all, a gross return of 15% still results in a net payment to clients of more than 10%.

During a period of single digit returns, or worse still losses, high fee structures can kill returns for investors. For this reason, Barron’s has noted that hedge funds have been forced to reduce both the management and performance components of their remuneration in order to retain clients. It is worth paying large amounts for the very best managers in the industry; but such people are few and far between.

Tom Elliott is a director of Beulah Capital and MM&E Capital.