In defence of hedge funds

It seems most people’s opinions on hedge funds generally fall into one of two categories: Firstly those who claim to understand them, and frequently criticise them in the process, and secondly those who admit they don’t understand them. The problem is those in the second category tend to listen or believe the opinions of those in the first.

And the problem for the hedge fund industry as a whole is that it’s an easy target, partly as the funds that make up the universe is extraordinarily broad and diverse. As a result, finding hedge funds or hedge fund managers who fit the negative stereotype is not difficult, in part because they’re the ones who get most of the publicity.

I have to admit to potentially being a little biased in the good versus bad hedge fund debate and, even if I’m not, most readers will assume that I am anyway. However, I would like to point out some facts about the hedge fund sector, while at the same time not avoiding the reality that not all of them are perfect, and only a minority are truly “best of breed”. Some of the best hedge funds appear in an article we publish today from Barron's (see Barron's best 100 hedge funds).

So firstly let’s look at what makes up the universe. ASIC, in its Regulatory Guide 240, is quite clear and correct when it states that there’s no firm definition of a hedge fund, but provides a range of features which it uses to identify them. These include:

1. A more complex investment strategy that aims to generate returns with a low correlation to equity and bond indices;
2. The use of derivatives such as futures and options;
3. The use of leverage or borrowing;
4. The use of short selling;
5. And finally, the charging of a performance-based fee in addition to a management fee.

Using the above five criteria when evaluating the performance of hedge funds creates a wide range of funds to choose from, each of which might invest in completely different asset types such as equities, bonds, credit, commodities or currencies which would normally not be associated with each other, and therefore rarely compared. Again, to see the performances of fund strategies go the Barron's article, Barron's best 100 hedge funds.

Adding to the complexity for the casual observer are that there are over 20 different strategies which each fund manager might use. And within each strategy there are further sub strategies or styles to complicate the analysis further. For instance, just taking those funds investing in equities, the database at www.fundmonitors.com divides the universe up into eight further sub strategies or styles.

To make matters worse, it doesn’t end there. Even taking equity long/short (the most popular equity type strategy) there are funds which specialise in specific market sectors, such are large cap/small cap, industrials vs. resources. Some go further and focus on small cap and emerging resource or gold stocks.

Styles differ also – quantitative and discretionary, as does the geographic universe or mandate such as Australia, Asia, Asia ex Japan, the US … and so it goes on.

The point of detailing all this is that the term hedge fund casts a very wide net indeed, and frequently there is little to no comparison or correlation between one end of the spectrum and the other.

The same can be said of performance, and indeed it is worth noting that one of the objectives of hedge or alternative funds for institutional investors is to diversify their exposure to a specific asset class so that when one (such as equities) performs badly others (such as bonds or commodities) provide some protection against the volatility.

So let’s take a look at the performance of hedge funds, and some of the other areas for which they are frequently criticised, with a focus on the facts.

As I have previously noted, the annualised performance of all 300 hedge funds in our database, including those investing in the wide range of asset classes described above was almost identical to that of the ASX200 Accumulation index (10.01%) over a 10-year period from January 2003 to December 2012, but with significantly lower volatility and risk characteristics.

The ASX200 Accumulation index fell over 44% in 2008-09, while the index of all funds fell 19.82%, less than half the amount. The worst month on the ASX200 was -12.61%, vs. -5.4% for the hedge fund index.

If I strip out the non-equity funds from the total universe, the performance of equity based hedge funds (in other words comparing similar assets) was significantly higher than the ASX200, but again with significantly lower volatility.

Click to enlarge

The reality, and the conflict, is that hedge funds are generally considered or described as risky, whereas the facts show that on average they reduce risk.

It’s worth noting that the fund performances above are net of fees, whereas no allowance has been made for any fees involved when investing in the index or trading shares. And while on the subject of fees it might be worth again noting the variance between what is generally accepted as the “2 and 20” model so often quoted, and the reality of hedge funds in Australia where the average quoted management fee is 1.3%, with a performance fee average of 13%.

It is often claimed that there’s a survivorship bias in hedge fund performance data, but that’s not always the case either. We include data from funds which have failed in the aggregated tables. The ASX200 for the record also has companies which are removed (ABC Learning, Babcock and Brown) to be replaced by survivors.

Of course these are averages, and averages can mask a multitude of sins. There are good funds and bad, and plenty in between. Research is essential, not only of past performance, but into the underlying asset class, strategy and sub-strategy used by a fund. Different funds using different strategies do provide different performance and risk criteria in different market conditions.

In previous articles I have listed the funds that consistently make double digit returns year in, year out. Maybe they’re in the minority, but they do exist.

The key is adequate information, (facts) and a proper understanding of the data, and then selecting a portfolio of funds to provide diversification of single fund or strategy risk.

If that’s not possible for all investors the old adage that one should never invest in anything one doesn’t understand probably serves as good advice.

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