Hedge fund debate: Picking the right hedge fund strategy

Participants

Fawcett, Fauchier Partners: lock-ups exist partly because of demand from institutional investors

CF, Fauchier Partners  If you take the HFR Fund of Funds Index as a proxy for the industry, and look at its returns over Libor, returns have been declining. However volatility has declined as well. So the rolling Sharpe ratio of the HFR Fund of Funds Index was at its highest ever, taking the 12 months to the end of 2003. Alpha appears to be declining but if you had leveraged the HFR Fund of Funds Index over the past 36 months, your returns would have been similar to historical levels and with similar volatility. Also, you must ask: "What type or quality of alpha?" The headline nominal numbers are coming down, but depending on whether you measure over Libor or as a Sharpe ratio you get a very different picture.

ED, Credit Suisse  There have been so many new hedge fund start-ups and so much money pouring into hedge funds recently that the dispersion of returns between the good-quality managers and the average managers has never been so pronounced – even within the same hedge fund style or strategy. I don't think alpha is declining per se: there are still very good quality hedge fund managers out there that are able to generate alpha consistently, it's just becoming more tricky to identify those managers. My job, which is sourcing those high-quality managers, has become more challenging. So, in brief, the race isn't over but it will become more important than ever to make sure you are betting on the right horses.

GI, Albourne Partners  Yes, we shouldn't lose sight of the fact that hedge funds are not a homogenous group. For aggressive equity-oriented managers, 8% to 10% would be at the lower end of their expectations. For some arbitrage strategies, 8% would feel like an outsize positive return. So one of the issues the industry faces is an investor base comprising both those who require high returns – high-net-worth individuals whose focus is mainly on the absolute magnitude of return – and Libor-plus institutional investors who care more about correlation, volatility and so on. At present those two investor groups are investing in the same structures and in future that may have to change because their requirements are very different.

JW, Hermes  As a pension fund, if we could get 8% to 10% pretty much guaranteed year in/year out, it would be fantastic. We have been in an environment in which returns have been low and for me therefore the question is, "Are we moving out of that environment?"

RHo, Barclays Capital  Exactly. Right now, volatility, credit risk and liquidity premia are all at their cyclical lows. At the same time, a lot of money has gone into hedge funds. Both factors have pushed down returns and will continue to do so. The big question is how hedge fund managers will adapt to this new environment.

CF, Fauchier Partners  Taking that point and also the fact that different investors want different things, I think we'll see more managers offering different types of risk off the same portfolio. Maverick have done it, for example. Then you ask where the manager has his own money. High-net-worth investors may prefer newer managers able to make money opportunistically from the latest inefficiencies without having to worry about volatility or Sharpe ratios.

DE, SG CIB  I agree 100%. With the exponential growth in hedge fund assets of late and the corresponding diversification of their investor base, what you see is a wide spectrum of returns, matching a wide spectrum of expectations and investor type. You still get very high annual historical returns from some managers but you have to muster the associated risks and high volatility. CTA's are a good example.

Choosing fund structures

OK, Permal  So how should investors go about choosing a hedge fund investment strategy? What are the options and their pros and cons?

RH, Mercer  Clearly the fund-of-funds structure is one of the easier options – easier certainly than looking for single-strategy funds. And the fund-of-funds approach also allows institutions to include some of the most cutting-edge strategies without taking undue risk because they can access them in a diversified way.

CF, Fauchier Partners  Despite most people's assumptions, there's no evidence that large funds have underperformed. As markets become tougher the theory that small is beautiful has been turned on its head. The large funds are better resourced, have huge clout with the investment banks, get better treatment and better service, and are less afraid of drawdowns and so do not become overly risk-averse in tough conditions. The private-equity groups are complaining that the big hedge funds can outgun them on recruiting talent, and they can certainly outgun the investment banks. So if you believe this is a talent-driven exercise, then perhaps size is an advantage.

RHo, Barclays Capital  And when you're trading complex strategies, you are dealing with more complex instruments and that requires more complex risk management systems and support staff and services. That argues for scaling. I think going forward you'll see some of the larger funds doing well by having the resources to adapt to the changing environment. The smaller specialists can also perform well but might have difficulty hanging on to their special expertise as markets evolve. Also, from time to time, there will be markets that offer potentially good returns – like energy – but the risks cannot be analyzed easily or indeed be hedgeable. Again, smaller funds might not be able to enter these markets easily.

GI, Albourne Partners  The environment has counted against the smaller firms too. For the areas that are attractive – multi-strategy firms, capital structure arbitrage, credit arbitrage – you have to have scale: you can't be a small multi-strategist. If you're going to be trading credit default swaps you need to be writing big tickets, you need to have lawyers on the staff.