However, the lack of regulation and little transparency is also
attracting the attention of numerous unscrupulous entrants.
Are
hedge funds worth the awesome high fees? Can they repeatedly deliver on
high performance? Why are they so hard to analyze?
Let us
look at new research that is just beginning to give us answers to these
questions.
Lack Of Transparency
By their nature, hedge funds lack transparency. That
is the critical factor that signals to experienced and knowledgeable
participants to beware. The lack of transparency manifests itself when
one attempts to standardize performance, risk measurement, or due
diligence.
From their point of view, hedge fund managers want to
protect their proprietary investment processes. They are not obliged to
reveal holdings or even meet with the typical client.
The holdings are audited annually but turn over many
times in the year, commissions are five times that of a prototype long
fund, and, hence, it is impossible for an outsider to measure the risk.
Hedge funds
perceive it as in their business interest to appear to be wizards hiding
behind the curtain.
This lack of transparency
is an advantage in attracting some skilful managers to the industry who
do not want consultants looking over their shoulders, telling them that
they are changing their style or taking too much risk against the
benchmark.
The
high fee structure is very
attractive to managers and salesmen.
A recent study shows that compared to traditional long-only investment
management, hedge funds have 10 times the fees at one-fifth the staff.
The high incentive bonuses do result in gaining of performance. And
that’s why studies reveal that a shoot-the-lights-out year of
performance is followed by three years of very plain performance.
Different Game
To the
mainstream investment industry, which is extremely conservative, the
challenge of finding and tracking hedge fund managers is proving too
great. The quantitative tools available are inadequate to control and
manage the risks of hedge funds. The interviewing skills and due
diligence cannot, before the fact, consistently detect failing
strategies or unscrupulous individuals. Efficient frontiers, assumptions
of normality, these do not work for a simple reason, these managers are
selling short! Traditional investment tools break down because – just as
you cannot use a hockey stick in a baseball game – it’s a completely
different sport!
The
quick answer of Value at Risk (VAR) doesn’t cut it either. VAR assumes
log normality, which underestimates the true risk of hedge funds when
there is short selling.
When the
manager shorts, there is an unlimited downside. When the manager gets
his short wrong, his short position increases. He is fighting the
natural upward trend of the market. Shorts have a small time horizon and
need constant replenishment, and many stocks cannot be practically
shorted. Also, there are more market rules to follow and you are
fighting management when you sell their stock short.
Few
track records go back 10 years. Back tests are particularly unrelated to
actual performance, including low correlations shown against
conventional benchmarks.
New research shows returns have a 2.43 per cent
annual survivorship bias. In long-only equity strategies, that’s the
difference between the median manager and the best long-term managers.
Total fees including performance fees take another 5 percent(Ennis and
Sebastian, Journal of Portfolio Management Summer 2003. So over a longer
term timeframe, the average hedge fund has at most a 2 percent a year
annualized return.
The
standard deviation of the hedge fund manager universe is nearly as high
as equities. And is the risk reduced by having a group of managers?
Research shows five to 10 managers gives you a 75 per cent
diversification. However, adding managers often increases risk by adding
different market exposures. You are not hedging in a multi-manager
program. When the sponsor is investing in long funds, adding additional
managers normally covers more of the market and reduces risk.
Furthermore, there is a herd effect by hedge funds making similar bets.
For example, recently the herd has been following long gold and oil.
Because they are enigmatic, they are often misclassified by managers and
potential investors. Hedge fund managers still swim in the same waters
as other investment managers. They are not diversifying so much as they
are merely applying different and large bets in selected investments.
Because of the immense probability of negative surprises, the Sharpe
ratio does not measure the skill of hedge funds.
Another
principle of finance that cannot be readily applied is that of time as a
diversifier. Over a longer period, a disciplined long-only manager will
normally achieve his performance objective as risks cancel out. Research
shows this is not the situation for hedge funds, largely because of
insolvency risk.
Losing all of your money is certainly risky.
That’s not simply having a short-term volatility in the strategy. And 10
to 20 per cent of the hedge fund universe goes bust in any given year.
Some high profile busts include Long Term Capital Management,
Manhattan
Capital Management, Maricopa Investment Corporation, and Lipper
Convertible Arbitrage. At an AIMR conference
earlier in 2003, a well-respected senior portfolio manager forecast that
80 per cent of current hedge funds will disappear within a few years.
Funds break down from fraud, misrepresentation of investments,
unauthorized trading, and insufficient funding.
Lack Of Due Diligence
To make
a difference in traditional risk/return tradeoff analysis, investors
need to allocate 20 per cent of their money to hedge funds, studies
show. This requires awesome support of consultant knowledge. It’s not
available. Perhaps a couple of the very biggest consultants can follow
some hedge funds, but, for the most part, consultants simply cannot
afford the infrastructure to do a proper job to educate themselves on
the many strategies and track the 4,000 managers in any prudent depth.
One bad
manager easily wipes out all the benefits of a hedge fund allocation. So
several managers are required in a program. The search must be diligent
as it is an unregulated industry, where few managers are well-known by a
reliable analyst. An on-site check, the smell test of sophisticated
institutional investors in long funds, is a waste of time in hedge funds
because the inspector rarely has the knowledge.
The
investor must pick several different types of managers, not based on
track record. The list of different hedge fund strategies alone can fill
a long list. It can even include strategies that rarely short sell. Many
of the fund-of-funds limit managers to $200 million in any strategy as
an optimal size to be nimble and some even limit the amount to $20
million.
Institutions are more often dealing with the opportunity to invest in
hedge funds by delegating the due diligence to fund of funds. But these
managers of managers, despite adding an additional layer of high fees to
astronomical high fees, are not usually doing significant due diligence.
If there are great risks in the industry, they are compounded by having
fund-of-funds.
Long/short
The first
hedge fund model was long/short equity hedge funds. About half of the
hedge funds out there can be identified by this description. They tend
to invest in equities, both on the long and the short sides, and
generally have a small net long exposure. This alone still is more risky
than long-only.
They are
genuinely opportunistic strategies capitalizing on stock picking skill.
A subset of that is ‘Market neutral hedge funds’ that seek to neutralize
certain market risks by taking offsetting long and short positions in
instruments with actual or theoretical relationships. These are
essentially long/short equity hedge funds that maintain long and short
portfolios of the same size and/or risk. It is nearly impossible to be
100 per cent market neutral in every period. There is no toolkit or
model available to offset all risks, so that it is a long/short
strategy, but it is only a question of degree of the magnitude of the
long direction.
In
brief, the industry is handicapped by few resources to cover the
4,000-something hedge funds.
Sam Wiseman is chief
investment officer at Wise Capital Management. (sjwiseman@wisecapitalmanagement.com)
