Investors aren’t the only ones finding it hard to make ends meet in a world of low returns. Hedge fund managers are in the same boat. Many of the anomalies they relied on to make returns investing in conventional markets have been arbitraged away. The recent performance of managed futures hedge funds, which trade on market momentum, is indicative. Returns fell 7% in the year to February, according to CSFB/Tremont. Convertible arbitrage funds were down 0.8%; short-bias funds returned just 4%.
Hedge fund managers would like to invest in more esoteric and volatile asset classes, such as emerging markets and distressed debt. These markets are less efficient and so offer more scope for outperformance. Hedge fund returns in these areas have been as high as 14% in the year to February.
But there’s a snag. Hedge funds are nowadays increasingly reliant on institutional investors, not just risk-taking wealthy individuals. And these risk-averse investors cannot easily follow funds into riskier markets.
How can hedge funds attract institutional investors while also embracing more ambitious trading strategies? The rocket scientists think they have found a way. They have devised a technique enabling investors to put money into rarefied hedge fund strategies without bearing the additional risk. Man Group, for one, is developing a product for UK pension funds based on the technique. And some hedge funds are even talking about using it to rope in retail investors.
How does it work? Imagine you run a pension fund whose trustees are permitted to invest only in low-yielding government bonds but that you need better returns. No problem. You can have exposure to the outperformance of a top-performing hedge fund manager in, say, emerging-market hedge funds, while hedging out the emerging-market risk.
Gains and pains
If this really is possible, mainstream investors can share in the returns of successful hedge fund managers, however fancy their particular strategy. But it’s worth pondering the associated costs.
For starters, there are fees springing from hedging out the market risk of the chosen hedge fund. Then there is the risk that the selected hedge fund fails to perform as it should – in which case the investor will suffer lower returns than if it had eschewed the rocket scientists’ plan from the outset.
Take a UK pension fund with £100 million invested mainly in low-yielding gilts. It invests 10% of the fund in a hedge fund specializing in emerging markets. In the past, the hedge fund manager has consistently outperformed the JPMorgan Emerging Market Bond Index by 2%, net of management and performance fees.
Then the pension fund enters into a swap agreement with an investment bank. It pays away the returns of the Embi and in exchange receives the performance of gilts.
Assuming the hedge fund manager delivers outperformance – alpha – the investor receives an extra 2% return on 10% of his fund. All in all, the fund then earns 0.2% more than if it had stuck with gilts – that’s what is known as the “portable alpha”.
But this is no free lunch. Structures of this kind normally involve an administration fee of about 0.2% on the hedge fund assets. The swap might cost anything between 0.2% and 1%. In theory, the investor ought to pay nothing in the above example, or even receive some extra spread, given that he is surrendering a higher return for a lower one. But in especially inefficient markets, where there is limited demand for derivatives, the cost could be much higher.
The bigger drawback is the risk that the hedge fund manager does not actually outperform. If it underperforms, the pension fund’s return could fall below what could be earned from gilts, because it would have to cough up under the swap contract, as well as paying the structuring fees.
So investors pursuing these portable alpha strategies must be satisfied about two things. One, that their chosen hedge fund managers can generate sufficient outperformance to outweigh the structuring costs. And two, that the hedge funds’ ability to generate this alpha really is sustainable.
Similar questions apply elsewhere in the investment world, for example whether it is worth paying for active management instead index tracking. But portable alpha represents yet another layer of structuring and another layer of fees. Investors need to be all the more certain of the answers to such questions.
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