Hedge Funds:Getting It Right
By: Shawn Menard
As pension funds scramble to generate more returns, they are investigating alternative investment sources such as hedge funds. However, Shawn Menard, of Russell/Mellon Canada, says the promise of absolute returns is not absolutely positive.
As the pension industry strives to ensure that asset returns are sufficient to meet its funding requirements, pension funds are reducing their traditional reliance on equity and fixed income investment strategies by diversifying into other asset classes such as real estate, private placements, and hedge funds. In the case of many hedge funds, their main selling feature is that they provide a stable return with reduced risk and the promise of absolute returns.
Unfortunately, this is not always the case. The promise of absolute returns, a defining feature of these funds, appears not always to be absolutely positive. So, it is critical to track management style and ensure that your hedge fund portfolios are providing stable returns without taking unnecessary risks.
Picking The Right Manager
When you compare the performance history of U.S. hedge funds to the results of the broad market, as measured by the Russell 3000 Index (see Table 1), you can see a big difference between the top performing managers and the bottom quartile managers. When managers do well, they tend to do very well. When managers do poorly, as we have seen in recent years, the results are often disastrous.
Consider what happened in 2002, a year when interest rates fell dramatically, the market also declined steeply and the median hedge fund manager had a return of -5.33 per cent.
When compared to the Russell 3000 return of -21.54 per cent, an allocation to hedge funds would have resulted in a better diversification of an investor’s assets and produced a greater overall return. When we review 2003 results, a relatively good year for equity and fixed income markets, the median hedge fund manager in our sample generated a solid, positive return of 22.56 per cent. In contrast, the median U.S. equity manager posted a return of 29.97 per cent, compared to the Russell 3000 return of 31.06 per cent. However, the difference between the top manager and the bottom manager in our hedge sample in 2003 was more than 1,660 basis points, while the range in traditional equity managers was 1,050 basis points.
Obviously, picking the right manager was important for investment performance from both traditional and hedge fund perspectives. However, returns by hedge fund managers showed greater variation than those achieved by traditional managers. Each year, the pattern is the same. Moreover, there is no guarantee that the best performer in one year will repeat that performance. On the contrary, some funds may actually give back all the gains made in the previous year.
In addition, there is the question of financial leverage. When you look at the huge dispersion of investment returns in 1999, the top performing fund posted a massive 332 per cent return, largely due to the use of leverage. Many funds often use leverage in their strategies. It is great to have when a fund’s strategy is firing on all cylinders, but can turn deadly in market meltdowns or when a strategy falls out of favour. So, it is critical that these funds have enough transparency to ensure that the risks taken are well-controlled and do not expose investors to any unforeseen risk.
A Question Of Style
Not every hedge fund shares the same investment style or premise. There are multiple management styles trying to exploit inefficiencies in the capital markets and managers have different levels of expertise in managing the various facets of these markets. Different managers specialize in different styles that can go in and out of favour in any given year. This can lead some managers to venture into certain areas without the knowledge of the client, with potentially disastrous consequences. What needs to be recognized is that style discipline matters, so it is essential that the fund managers you hire stay within the confines of their given management style.
Many hedge fund investors have taken the fund of funds approach to diversify manager-specific risks, as most fund of funds typically employ between 15 and 20 managers. In our fund of funds sample, there was a sharp reduction in the range of return patterns because the funds are properly diversified in baskets of other hedge fund managers. Also, this approach provides a valuable risk control oversight mechanism by ensuring that fund assets are properly diversified among a large pool of uncorrelated managers, which has the effect of dampening the dispersion of returns.
From 1999-2003, the median fund of funds manager posted absolute returns in each year, beating both the London Interbank Offered Rate (LIBOR) and the broad market soundly. The only exception occurred in 1998, when the market rose 24 per cent and the median fund of funds posted a loss of -2.38 per cent. This year also registered a high dispersion between top performing managers and poor performing fund of funds. The market meltdown caused by the Russian debt defaults and, subsequently, the demise of Long Term Capital Management (LTCM) had a major affect on all hedge funds during this period – one from the financial fallout caused by the market and the other from the negative shadow cast on the industry by LTCM.
Overall, the fund of funds approach does help to mitigate excessive risk taken by one manager which may ultimately jeopardize the performance of the fund. This approach also lowers the risk of picking the wrong fund of funds since the level of dispersion between different managers is lower.
The main conclusion to be drawn from Russell/Mellon’s research data on hedge fund returns is this: Absolute return strategies are not always absolutely positive and picking managers is extremely important in determining what type of results you wish to experience.
Nevertheless, while these results are helpful at highlighting differences between managers, they say little about how these returns were generated and what risks were taken.
In public markets, the science of attributing returns has come a long way in determining manager ability to add alpha on a risk-adjusted basis. However, these techniques are difficult to transfer to alternative managers because there are only a limited number of benchmarks that truly reflect a manager’s investment style or philosophy and they do not provide investors with a passive alternative. Another issue compounding the problem is that many hedge funds are reluctant to provide underlying transaction and holdings information necessary to accurately assess the skill of a manager.
However, it is important to delve deeper into a manager’s performance, as skill clearly matters, particularly in light of our universe sample results. There is simply too high a price to pay for picking the wrong manager.
Finding The Right Solution
The solution lies in finding a compromise that does not impede a manager’s ability to manage the portfolio according to a given strategy, but must permit proper oversight of the portfolio to ensure pricing of the assets are fair and the risks taken are consistent with the fund’s objectives. Traditionally, oversight of hedge funds has relied on information provided by the managers, which protects their positions, but may come at a cost.
Each manager usually provides different data, which makes comparability next to impossible. Also, the quality of the information is unknown. Even if holdings data are provided, accounting information may not help. What is really needed is economic exposure data that reflect the portfolio’s true risk. Only then can we begin to ascertain whether the performance has added value on a risk-adjusted basis.
While managers often do provide their own analysis of the risks inherent within the portfolio, the information provided may be biased, however unintentional, as it reflects their view of the world. Consequently, the information provided does not take the plan sponsor’s view of risk into account. Also, this risk information cannot be verified, nor incorporated with the risk information of the fund’s assets.
Going forward, it’s vital that we develop techniques to compare managers across strategies and within the context of the total fund portfolio. The industry needs to be able to view managers in a holistic way, so that the plan sponsor can understand the risk exposures of each manager and the total portfolio program. Only then will we have the full capability to measure these strategies in a consistent way and determine their added value.
Hedge funds offer plan sponsors an attractive opportunity for adding alpha to their portfolios on a risk-adjusted basis. Picking the right manager is a critical success factor in achieving this objective. And, once a manager is selected, effective monitoring and oversight become critical, ongoing elements in the process that will ensure the program meets its investment goals.
Shawn Menard is managing director of Russell/Mellon Canada.
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