Dispelling hedge fund myths

PORTFOLIO POINT: With proper research and a diversified strategy, hedge funds can be a good defensive investment play.

In spite of hedge funds having a reputation for being highly speculative and excessively risky, the reality is that the sector as a whole has significantly outperformed the underlying equity market over the past 10 years. Furthermore, they have achieved this by protecting capital during periods of high volatility and falling markets.

Chart 1 below shows the cumulative performance of the ASX200 Accumulation index against an index of all Australian equity-based hedge funds since January 2003. Clearly, in the strongly trending bull market leading up to the global financial crisis, hedge funds underperformed as a result of the cost of their short exposure or “hedge”. However in Chart 2, which shows the cumulative performance since November 2007, the outperformance of hedge funds has been dramatic.

Chart 1: ASX200 Accumulation index vs Equity Based Hedge Funds January 2003 to April 2012
Chart 2: ASX200 Accumulation index vs Equity Based Hedge Funds November 2007 to April 2012

And, in spite of the stark reality of the numerical facts, hedge funds remain tagged with the reputation of risky and highly volatile, or even speculative investments. In the words of Professor Julius Sumner Miller (for those of you who can remember him): “Why is this so?”

Much of the reason can be attributed to the media’s minimal understanding of the sector, but this in itself is both a product and the fault of the hedge fund industry itself. The sad reality is that for all the excellent funds providing investors with absolute returns and protecting their capital in volatile markets, there are others (thankfully in the minority) which provide wonderful headlines for sub-editors: Think Basis Capital, for example, which in spite of multiple recommendations from research houses was one of the first hedge funds globally to implode in 2007, following 59 consecutive positive monthly returns. Or Trio’s Astarra Fund which, thanks again to sloppy research reports, saw more than $120 million of investors’ money disappear in a Ponzi scheme.

Thankfully, these examples are in the minority, but they certainly make it hard to mount the argument that hedge funds represent a risk-averse option when markets become dysfunctional.

Another reality is that while the charts and results above show the average returns of the 160-plus equity-based funds in Australian Fund Monitors’ database, the range of returns and the investment strategies employed by hedge fund managers can and do vary dramatically. There are certainly those who are high-conviction investors or traders with concentrated portfolios who can provide significant or even spectacular returns, but who at the same time generally have significantly more volatility than the average investor can tolerate, particularly in negative markets.

So, having provided examples of disasters and accepted that some hedge fund managers fit the stereotype of taking high risks and being speculative, it is worth remembering that on the other side of the ledger there are those managers and funds whose primary consideration is risk. For example, one Australian fund, Fortitude Capital, had positive returns every month in 2008, while 24% of the funds in Australian Fund Monitors’ database provided investors with a positive return in 2008.

The great difficulty for investors is that there is so much diversity in the style, strategy and performance of hedge funds and, as such, this makes it hard to select one from the other. To most investors, and many of their advisers, hedge funds are a homogenous group that are all too easily placed in the same bucket.

So how does an investor make a selection to avoid the high-return/high-risk type of fund, and select the risk-averse, capital-protection style? While all the literature and risk warnings will tell you that past performance doesn't guarantee future returns, it is past performance – coupled with an understanding of how a manager generates their returns – which can give you the best idea of how a fund will perform when volatility hits the market.

The problem is that many managers, and a significant proportion of investors, focus on “upside” or positive performance. With the ASX200 remaining more than 30% below the peak reached in November 2007 pre-GFC, the focus should be equally on the downside performance, or risk that the manager exhibits. Investors should consider the fund’s largest previous losses, and the percentage of months when performances were negative. Check the fund’s annualised return against the annualised volatility, both of which are used to calculate what is known as the Sharpe Ratio*.

Finally, ensure that you are diversified across multiple funds. Remembering that all hedge fund managers are trying to do the same thing, but frequently in very different ways, means that you should not be exposed to single manager risk, any more than you would only invest in BHP, or one bank stock. Even the best of managers have negative months, but selecting a portfolio of funds with different styles can be one of the best defences in volatile times.

Chris Gosselin is chief executive officer of Australian Fund Monitors Pty Ltd.

*Sharpe ratio: A measure of a fund’s “risk-adjusted return”, or the return per unit of risk. The higher the ratio, the less risk the investment strategy has generated. The ratio provides an indication of whether the returns were generated from manager skill or risk-taking. It is calculated as follows:

Sharpe ratio = Excess Return / Risk

Where: Excess Return = Annualised Return since the fund’s inception minus the Risk-Free Rate of Return (i.e. RBA cash rate)

Risk = Annualised Standard Deviation since the fund’s inception (i.e. volatility in returns as measured by the deviation from the average or mean)