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Hedge Funds Go Mainstream

By: Clive Morgan

Concerns about the financial solvency of pension plans have prompted plan sponsors to seek other investment strategies. Clive Morgan, of York Hedge Fund Strategies, explains why hedge funds are a viable alternative.

Imagine for a moment that the year is 2006. At a news conference held in June of that year the chairman of AIMA (Canada) states that Canadian institutions now consider hedge funds “mainstream” investments. They now use hedge funds as replacements for the old traditional investment methodologies to both manage the risk and provide enhanced risk adjusted returns for their total portfolio.

What has brought this about?

The events leading to this change in thinking had their roots in the four-year period 2000 to 2003 which encompassed three years of a brutal bear market (will that period be repeated?) followed by a recovery in 2003. By the end of 2003, many pension plan sponsors were concerned about the financial solvency of their pension plans and the impact on the beneficiaries and the corporation. They realized that they needed to protect capital and earn returns in excess of the liability discount rate over their typical three-year valuation cycle. They could no longer rely solely on long terms, such as 10 years or more, to earn the required returns, but needed to earn at least the liability rate every one to three years.

Facing these issues, investment consultants and plan sponsors began in 2004 to analyze the role that alternative investments would have in meeting these concerns. By that time, investment consultants were already allocating significant resources to building databases and analyzing the returns and risks of using these investments in a portfolio, either through an actual policy allocation or through a portable alpha program.

Impact Of Hedge Funds

An example of this analysis considered the impact of hedge funds on the total portfolio risk. Institutions knew that historically the annual standard deviation of a 60 per cent equity and 40 per cent fixed income portfolio had been approximately 10 per cent. Their analysis had also shown that the annual standard deviation for each asset class had been reasonably constant over time and, finally, that recent history had shown that in times of crisis, diversification between equity asset classes tends to dissipate and did not provide the protection desired (correlations change and move to one in times of crisis). Table 1 shows the results of their modeling on the return and volatility on the total portfolio by allocating 10 per cent from the equities to a diversified fund of hedge funds. It was accepted that the historic ‘pattern’ of returns would be a good indicator of what could be expected in the future in terms of risk.

These periods represent both ‘Bull’ and ‘Bear’ markets. The table shows that a modest 10 per cent allocation would have reduced the annual risk of the portfolio by an average of 1.2 per cent and improved the Sharpe ratio by 0.16 or 16 per cent. These figures were considered significant in improving the risk management of the total portfolio.

As a further example, Graph 1 shows the impact of increasing allocations to a fund of hedge funds over the entire period 1990 to 2003. In this graph, the Sharpe ratio is shown as a monthly rate.

The results show that the monthly Sharpe ratio increased until an optimal weight of 70 per cent was reached. Although it might be considered aggressive to allocate 70 per cent of a portfolio to hedge funds, it should be considered that hedge funds are simply an extension of traditional trading strategies with a far more intense focus on capital preservation in lieu of the tracking error. The hedge fund strategies used encompass fixed income, large cap, and small cap equities on a global basis, emerging market allocations, and managed futures.

The consultants and plan sponsors felt that it was impossible to forecast the return for any one asset class. But they realized that hedge fund returns – which are primarily due to the active management premiums for economic risk, liquidity, and complexity – should perform better than the traditional asset classes on a risk-adjusted basis.

The change from alternative to mainstream has occurred a number of times before. For example, change was seen in the 1970s and 1980s regarding real estate and international equity. As investors became more comfortable with these investment classes, and as more funds used them, they became mainstream as hedge funds have now done.

Other issues raised by the early investors included:

How does an investor know which of the 6,000 hedge funds to invest in?

The answer is they don’t have to. Fund of funds managers use screens such as type of strategy, assets under management, and experience (track record) to reduce the number of individual funds that meet their criteria. However, this issue is not unique to a fund of funds manager, as similar questions could be asked of a global equity manager who has 90 to 130 stocks in their portfolio with a further 100 to 200 under consideration out of a universe of more than 10,000 equities to select from. The process used to select investments by the two investment organizations is similar, as they both do company visits, balance sheet analysis, and review organization plans. The fund of funds manager, however, also focuses on downside risk and diversification to build its portfolio for positive absolute returns.

How should the investor manage the risk in the portfolio and meet its fiduciary obligations?

Since institutions have started to invest in hedge funds, the managers are providing clearer transparency and, for some products, full transparency. However, the investor must ensure that the fund of funds manager has the necessary processes set up to measure the risk in the portfolio and the individual strategies. As a minimum these would include weekly performance data and an overall analysis of the portfolios. The full portfolio must be available when they visit the underlying managers and they should hold discussions regarding stress testing and downside analysis. Finally, the fund of funds manager should be looking at the operational risk of the business and economic environments.

The processes are no different for a traditional manager who visits companies and looks at the quality of earnings and the balance sheet. They also do downside risk analysis based on their view of the economy and the specific industry.

Why are the fees higher than those on long-only investments?

The fees should be considered in relation to the actual net returns. Early investors realized that the fees were needed to pay for the alpha (skill) provided by the manager and bore little or no relation to any return due to the change in an index (beta). Using this basis, the fees charged relative to the skill of the manager could be compared to the fees the traditional managers were charging for their out-performance of the appropriate index. In addition, the fees have a performance component aligning the objectives of the manager with those of the investors.

Alternative No More

There is little doubt that investor perceptions of hedge funds as alternative investments started to change with the founding of AIMA (Canada) in 2003. AIMA quickly became the voice of the hedge fund industry in this country, providing education and research on alternative investments to investors, documenting sound practices, and working with regulators. Initially, AIMA (Canada) had 50 corporate members who took on this important role. Now, in 2006, we can look back, on their dedicated efforts with a sense of pride and say ‘hedge funds truly are mainstream.’

Clive Morgan is director of York Hedge Fund Strategies and co-chair of the AIMA (Canada) education and research committee.

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