The secret of successful hedge fund investing

PORTFOLIO POINT: Investors should look at diversification to reduce risk when investing in hedge funds.

Hedge funds have consistently beaten shares in recent years – it’s one of the reasons many investors are taking the time to examine this area of the market. But crucially, it’s most important that investors understand that 'hedge funds’ is a widely defined term. Individual funds have dramatically different returns and there is a wide spectrum of returns even between different categories of funds.

In a recent article I explained how hedge funds were outperforming. But I realised quickly what Eureka Report members wanted to know was: which funds do best in what circumstances? Today I’m going to try and answer that key question.

But I want to take a moment to review the issue of performance. This is best shown in Chart 1, which shows the 12-month performance in each of the past five years compared with the ASX200. Although hedge funds on average lost close to 17% in 2008, this was mild by comparison with the fall in the ASX200 of over 41%. And while the average hedge fund underperformed the market in 2009, they outperformed in 2010 and 2011 to prove the adage that the best way to make money is to ensure you don’t lose what you already have.

Chart 1: Average returns of all hedge funds vs ASX200

However, while hedge funds might have outperformed equity markets, that doesn’t mean they’re all the same. In fact the variation between funds is considerable from a strategy, implementation, asset class, risk and of course a performance basis. And seeing that risk and performance, or more correctly the risk adjusted performance is normally front and centre for most investors, let’s start there and work backwards towards analysing the strategy, asset class and implementation for selecting defensive funds.

Chart 2 indicates the best-to-worst range performances of hedge funds in each of the past five years. Some excellent, some average, and some downright ugly. What is interesting to note is the larger ranges in the more volatile years of 2008 and 2009, and how fund selection is vital to the process. It is fair to say that there is no such thing as an 'average' hedge fund, given that in 2008 the best made over 200% while the worst lost close to 75%.

Chart 2: Range of hedge fund performances 2008-2012 YTD

Chart 3 shows that drilling down into the data uncovers that in 2010 the 20 best performing funds returned between 24% and 107%. However, many of those same funds were amongst the 20 worst performing funds the following year, with 13 of them losing over 10% in 2011.

Even though in nearly every case the positive performance in 2010 was sufficient to provide a positive return over the two-year period, few investors would have the risk profile not to have lost sleep in the process, as only five provided respectable returns in both years.

Chart 3: Rooster one year, feather duster the next!

Sceptics could undoubtedly argue that this was further proof, if needed, that hedge funds are both volatile and risky – as indeed they can be if merely selected based on pure headline performance. However, it also reinforces the advice that any investment in a managed fund should only be made after careful research, and are not suitable for short-term trading or market timing – that’s what the manager is being employed to do.

So let’s run through five basic rules and processes for analysing hedge funds, remembering that unlike traditional 'long-only' managed funds, which attempt to either track or outperform the market but are broadly hostage to its ups and downs, most hedge funds aim to provide an “absolute return”. In other words, positive returns in all market conditions over the investment cycle.

1. Diversification reduces risk. Hedge funds are no different to any other investment class in this regard. Investing in a single fund creates a concentration risk, so unless you invest in a multi manager or fund of funds, your risk is focused on that fund, and its investment manager.

2. Diversify the underlying asset class. Unless you are using hedge funds to provide specific exposure to equities, broadening the underlying asset class the fund invests in can provide lower risk. Specific funds focus on strategies including credit markets, commodities, precious metals or foreign exchange, or in the case of “Global Macro” a combination of them all.

Chart 4 shows the performance of various strategies and underlying market sectors over the past 12 months has been equally diverse. Further proof, if needed, that research, understanding and selection are vital when considering hedge funds. However, also understand that these so-called alternative markets can also be volatile, and more recently the correlations between them have been higher than in the pre GFC days.

Chart 4: 12 month performance by strategy
3. Understand the fund’s investment strategy and sector. While it might not be easy, or possible to understand in detail how the fund manager operates, by reading the offer documents or research you should know the market sector the manager focuses on, the level of stock concentration, how risk is managed, how much market exposure or leverage is taken, and if or how derivates are used. For instance, some funds have highly concentrated investment portfolios which focus on a narrow market segment such as mining and resources, or the small cap sector.

These undoubtedly have the potential to outperform in some market conditions, but tend to become oversold or illiquid when markets become dysfunctional. In the same way some managers develop specific investment themes around the macroeconomic environment or an industry sector, and concentrate the portfolio accordingly, this can lead to significant gains provided the theme’s logic prevails. However, themes can change (think the never-ending China resources demand theme) and unless the manager has seen it coming, so too can performance.

4. Understand the manager’s approach to risk. Although part of the overall investment strategy and implementation, risk management, and the philosophy to taking risk, varies significantly from fund to fund as it does from investor to investor. Therefore although the risk environment changes through various market cycles, it is only logical to match your risk tolerance as an investor with the risk style and record of the fund manager. This becomes increasingly important when markets are volatile, but remember that in positive markets risk is frequently rewarded, and after losing money most investors hate missing out on the rebound.

5. Do the numbers. At Australian Fund Monitors (AFM) we use a series of Key Performance Indicators, or KPIs to quantify and rank each fund’s positive and negative performance (risk) over a series of time frames, and under different market conditions, and compare these against the market, their peers and cash.

In addition to simple returns over the medium to longer term, consider the percentage of positive monthly returns, the quantum and average of past positive and negative returns, and the extent and duration of previous drawdowns. Various ratios, but particularly the Sharpe ratio, which measures past risk-adjusted returns, try to encapsulate all these into a single number.

In particular, in volatile markets check how a fund has performed in similar circumstances. While everyone will say past performance is not guaranteed to continue, a fund’s past track record does provide an understanding of how they might perform under specific conditions in the future.

So, armed with these five basic rules, which funds to invest in as a defensive strategy?

• Focus on funds which focus on risk. You may not make spectacular gains, but you should avoid nasty shocks.
• Consider some exposure to non-equity based funds, but bear in mind these markets can be volatile also.
• Avoid thematic funds, unless you agree with the theme. Small resources provided great returns in 2009-10, but liquidity and macro themes changed in 2011.
• Avoid leverage – although there’s not as much about as there was.
• Avoid concentration – both of funds and in the fund’s underlying portfolio.
• If the level of research is too complex, consider a well-balanced multi-manager or fund-of-funds, bearing in mind there will be an additional layer of fees involved – but still do the numbers on past performance and risk.
• Seek risk averse, flexible managers who can rapidly adjust to macro conditions.

In this article we haven’t tried to cover a range of other rules and aspects of hedge fund investing, including how their fee structures work, due diligence, operational issues, compliance, key person or counterparty risk – all vitally important issues, even though the bottom line is performance – and risk!

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