Are hedge funds still worth considering?

I was recently asked by a friend if hedge funds still had any place in a portfolio. The question doesn’t surprise me given the negative press, what with Buffett and many others highlighting how hedge funds on average generate below market rates of return and charge high fees in the process. Indeed, when one analyses the hedge fund indices, which are a composite of managers, it makes perfect sense to question their relevance. Looking only at the hedge fund indices though, is misleading.

There are thousands of hedge funds today, running a plethora of different strategies from those with long market bias, or high beta exposure, to those with no market exposure or that run net short books, or negative market exposure. Some managers will be excellent; others will be poor. The weaker managers may be included in the index for a few years, at least until they close shop. Taken altogether, the good, the bad, the ugly and the different, their returns will converge, to a relatively dismal print.

There are, however, some excellent managers that generate substantially more than the typical long only index and at much lower risk. Effective hedge fund selection is thus critical to adding alpha or performance.

Source: Sussex partners

Furthermore, many managers can generate excellent returns whilst having a very low, if any, correlation to the traditional indices or each other, generating strong alpha without the beta.

This makes them an ideal component of any portfolio as they can add to the diversification of returns, whilst also reducing risk. Within a well structured portfolio, hedge funds can therefore increase returns for a certain risk level.

It’s important to select managers that have a consistent, repeatable process that generate strong returns, with diversified, uncorrelated alpha, whilst also being able to manage risk budgets and limit drawdowns.

In the case of long-short equity, for example, I favour managers that are strong fundamental stock pickers with a valuation tilt. The ideal is a manager that can outperform the market on the way up, using a relatively low net exposure, and can also limit drawdowns when the market turns downward. There are several such managers.

The selection process is not as easy as it sounds, however, especially for the average investor. Firstly, one must get the historical performance data to analyse and there are only a few service providers, all of which charge for releasing it.

Secondly, one must analyse the monthly reports, to better understand how the manager is deriving their value add. These are not easy to get hold of, as some managers need/wish to do KYC (know all about your investment ability and background and that you are accredited investors, etc.), before they will even speak with you. This is simply a reflection of the increasingly pedantic regulation around hedge funds, which may prove detrimental for the average investor, as they are then biased towards long only products which potentially carry more risk.

Another issue that most investors will have is accessing the hedge fund of their choice. Most banks claim to have open platforms, but in many cases this is simply not the case. Indeed, I have found that many banks have little experience or capability in hedge fund selection and are more focussed on the traditional long only type of product.

Having worked in a large global Fund of Hedge Funds, I have a relatively wide network of managers and researchers to tap into, to source the ‘best of breed’ managers. This extensive network allows me to find the diamonds in the rough so to speak and also to get preferential terms with the managers.

Hedge funds should be included in most portfolios as they are an excellent diversifier. But they should be incorporated in a way suitable to the portfolio’s risk budget and market environment.  For example, given the risks in the current equity and bond markets, I currently favour an ‘all-weather’ type of approach to portfolio management, taking exposure to all the major asset classes, including gold and hedge funds.

Given their ability to control drawdowns, I favour a select number of long/short equity managers, over holding equities direct, as well as a number of Fund of Hedge Funds (FoHF) that have proven their ability to adjust exposures in uncertain market environments. My expectation is that these managers will provide returns in an up market, but also insulate the portfolio in a market decline.

Indeed, in our long-term strategic allocation, hedge funds are roughly 1/3 of total allocation. The rest being spread between fixed income, equities and gold.

Disclaimer:

This post is intended only for accredited or institutional readers, as defined by .The information presented herein is considered reliable at the present time, however, we do not represent that it is accurate or complete, or that it should be relied upon as such. Performance data is based on bank reports and is dependent on fund filings and bank reporting. As such they should be seen as estimates and regarded for information purposes only and should not be relied upon. Speculation or stated beliefs about future events, such as market and economic conditions, company or security performance or other projections represent the beliefs of the authors and do not necessarily represent the views of MW Capital Management PteLtd. Nothing in this document should be perceived in any way as a recommendation or offer to buy or sell any security or fund. Any individual securities or funds mentioned are simply an example of areas we are currently invested in and will not be suitable for all investors. Any views and current investments may and will change over time and should not be relied on in any way.This document is not an offer to sell nor is it the solicitation of an offer to purchase any services offered, or any fund managed or recommended, by MW Capital Management PteLtd. In no way should this post be considered as being approved by any regulator or regulating authority. Investment in hedge Funds can involve total loss of principle and are meant for sophisticated investors who understand and can afford the total loss of their investment. Many hedge Funds use leverage which can exacerbate losses. Past performance is not indicative of future returns. It is intended only for accredited investors, domiciled in countries in which collective investment schemes are permitted for public distribution, offering and sale under the applicable local legislation. General business, market, economic and political conditions could cause actual results to differ materially from what the authors presently anticipate. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. The views expressed may change without notice. All investments involve risk, including the potential loss of principal.