| Investors on hold with hedge funds |
With equity markets worldwide losing over a fifth of their value last year, bringing further pain and anxiety to institutional and private investors, hedge funds attracted renewed attention and scrutiny. Was this the time for mainstream investors finally to embrace them, or would it be better to harden resistance to their allure?
A sceptical view seemed to have some support – plenty of hedge funds closed down in 2002. At the same time, though, some hedge funds with simple and clearly logical strategies, such as dedicated short-bias equity funds, returned between 15.84% and 18.14%. That compares with -23.37% for the S&P500. Yet the interest shown by institutional investors in such funds has been more cautiously curious than enthusiastic.
In many cases institutional investors met hedge fund managers but left with their money in their pockets. “There’s been a lot more talk than action,” says Andrew Raisman, associate director for UK institutional business at Baring Asset Management. “For a lot of pension funds it’s a case of ‘we’ve got so much else to worry about so why look at hedge funds now?'”
Even after many consultants recommended a 5% to 10% allocation to hedge funds, most institutions left without taking out their wallets except to pay their consultants. And of those that took their advice, hardly any committed as much as the 5% to 10% of assets suggested – the notable exceptions being a handful of US university endowments and Swiss pension funds.
There is evidence that the allocation from institutions to alternative investments such as hedge funds is increasing slightly from its traditional 1% to 2% of total assets. But on the whole, considering the dire performance of equity markets, what is more interesting is the extent to which institutions continue to stay away.
“We continuously educate ourselves on hedge funds,” says Giles Craven, managing director of Shell Pensions Management, “but we felt that the appetite of the trustees just wasn’t there.” A key concern for the Shell trustees was the lack of transparency, especially from US hedge funds. “European hedge funds understood our need for transparency but US funds just couldn’t understand it. Their attitude was ‘hand over your money and we’ll give it back to you plus whatever extra – and that’s it’.”
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Institutions are sophisticated, rational investors, and the reasons why they remain reluctant to invest in hedge funds cannot simply be dismissed as conservatism. According to a Deutsche Bank survey on alternative investment trends released in January, performance versus fees, transparency, and risk versus returns are still the biggest issues for investors, although their relative significance is changing.
Concerns about transparency and risks versus returns have fallen slightly compared with last year’s survey but concerns about performance versus fees have increased and now weigh heaviest. There is good reason for this. A study by Clifford Asness, Robert Krail, and John Liew of AQR Capital Management, a US hedge fund manager, revealed disconcerting statistics about the performance attributable to the skill of hedge fund managers.
In the 2002 paper, the researchers argued that monthly beta (market risk exposure) statistics for hedge funds tended to be understated because many hedge fund portfolios have large proportions of illiquid securities whose month-end pricings are often intentionally or unintentionally inaccurate. By using three periods of lagged beta figures to get a more accurate reflection of market exposure they calculated alpha (the proportion of hedge fund returns attributable to managers’ skill) by looking at the performance of the CSFB/Tremont index and its sub-indices.
What they found was that for the period of their study (1994 to 2000) the alpha for most hedge fund strategies and for the aggregate index as a whole was “not statistically significant”.
Closet index trackers
They also found that over the period of the study most hedge funds provided little diversification value. In the case of the aggregate index, they estimated the summed lagged beta (performance attributable solely to market risk) to be 0.84, more than double the reported simple beta estimate. This means that if the market was to fall by 10% the value of the hedge fund portfolio would fall by 8.4%. The paper’s assumption that illiquid securities are inaccurately priced is a strong one that not all would agree with. Also, given that the paper covered a bull market period, a high market exposure could have been intentional. Data covering the period 2000 to March 2002 show substantially improved alpha figures for the aggregate index and most sub-indices, suggesting that hedge fund managers added value over this period. The more recent data also confirmed, however, that hedge funds are more correlated to equity markets than many would like to believe.
There are other reasons why institutions continue to stay away from hedge funds. Hedge fund managers say it is partly because institutions are unwilling to sell out of equities at current low prices and so do not have the spare money to invest in hedge funds.
Another is that the reputation of hedge funds as a whole is still tarnished by a few spectacular and infamous collapses. The crash of the respectable Long-Term Capital Management in 1998, whose shareholders included two Nobel laureate economists, sent shock waves around the world.
More recently, the collapse of mortgage arbitrage fund Beacon Hill, which closed with $400 million of losses in October 2002 after revelations that valuations were 40% overstated, reminded investors of the risks of investing in opaque funds.
The collapse on January 15 of Japanese hedge fund Eifuku served an additional reminder of how quickly things can go wrong. After returning 76% in 2002, the $300 million fund lost 15% of its capital in the first two trading days of 2003.
Professionals in the broader financial market have their own theories about hedge funds too. “Institutions do not invest in hedge funds because they see through them,” says the head of institutional equities at one global brokerage. The global head of equity capital markets at another investment bank finds the extensive cross-investment between hedge funds and funds of hedge funds worrying because it leads to a concentration of risk. “If one fund were to collapse,” he muses, “it could bring down others in a way reminiscent of the Lloyd’s of London syndicates in 1989”.
Even regulators are starting to form an opinion. Having previously been content to allow hedge funds to operate unregistered and largely unsupervised, the SEC is now in the midst of its broadest ever investigation of the industry. It is also investigating the activities of Gotham Partners Management and three other short-bias funds to see if they manipulated the market.
Across the Atlantic, George Soros, perhaps the most famous hedge fund manager in the world, was convicted by the French government on charges of insider trading and fined $2 million.
In Asia, regulators are talking about opening up hedge funds to retail investors.
Hedge fund data are notoriously bad and one of the biggest problems for investors is the relatively short time series for which they are available compared with equities and bonds. Hedge fund indices are also of only limited usefulness for a number of reasons. One is that none of them have data covering much more than 50% of the industry by assets. Also, because hedge funds come and go with a much greater frequency than other types of funds, hedge fund indices have a bias towards the survivors that tends to produce an unduly flattering picture.
It’s almost impossible to obtain a clear picture because the industry is so heterogeneous. It is possible to categorize individual hedge funds into a broadly defined strategy group – such as statistical arbitrage, managed futures or global macro (now enjoying a resurgence) but that is not the end of the story. Even within these categories the particular inefficiencies or asset classes that individual hedge funds are targeting can make them very different. The risks and rewards involved in a particular hedge fund are unrelated to those of the notional average hedge fund.
Murky picture
Estimates for the growth of the hedge fund industry in 2002 range from an increase of 10% to a contraction of 7%, based on an estimated size of $600 billion. The picture for the performance of hedge funds is also murky. The weighted CSFB/Tremont Hedge Fund Index was up 3.04%, the equally weighted MSCI Composite up 3.72%, and the equally weighted Hennessee Hedge Fund Index down 3.43%. Exactly how successful specific strategies were also varies considerably from index to index: the performance of macro funds for example varies from 14.66% to -3.02%. It’s also interesting to note that even the worst-performing hedge fund sub-indices for 2002 vastly outperformed standard equity indices. According to the Hennessee group, over 94% of hedge fund managers in 18 of the 23 sub-indices beat the S&P500 and in 14 of the sub-indices 100% of them did.
Tremont Advisors estimates that up to 1,000 hedge funds (mainly small ones with less than $20 million invested) of the 6,000 existing in 2002 shut their doors. It expects a similar pattern this year, with the number closing outpacing the rate of new openings.
Nevertheless, according to the Deutsche Bank survey of hedge fund investors, 62% of respondents say they plan to increase their allocation to hedge funds in 2003. The greatest increases are planned for long/short, macro, multi-strategy, market neutral, and distressed debt funds. European hedge fund managers also believe that there are still substantial inefficiencies in the European credit derivatives market and that capital structure arbitrage, a strategy that exploits discrepancies between the equity and debt of a company, is still underdeveloped in Europe.
Opacity, heterogeneity, complexity, and the occasional blow-up continue to keep most institutional investors away from hedge funds altogether. The big picture may be clouded but it may not be very important. The notional average hedge fund or average statistical arbitrage hedge fund doesn’t exist.
There are hedge funds, funds of hedge funds, and cash-plus products with alternative alpha components that target inefficiencies or opportunities that are not overly obscure or complex. When things are desperate it might be worth taking a well-calculated risk.
