Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 173

Why bother with hedge funds?

If you read the typical hedge fund headlines, you’d think institutional investors were abandoning them in droves. Common issues cited include subdued performance and high fees. In this article I discuss hedge fund performance, the role they play in multi-asset portfolios and how we manage hedge fund investments.

It’s intriguing to hear about well-known investors redeeming their hedge fund assets for performance reasons, and I’m curious about their expectations and whether they were reasonable.

Given there is a huge range of hedge funds available, it also makes me wonder if the investor had any constraints (perhaps related to resources, experience, fees or liquidity) and whether these were consistent with their expectations of the hedge fund manager. Perhaps their liquidity or fee constraints prevented them from hiring better hedge fund managers. The fact is that many hedge fund investors are pleased with their chosen hedge funds and that net flows from institutional investors have been positive for many years, with the exception of the last few months. Recent reports from Barclays (Coming to Terms) and JP Morgan (Institutional Investor Survey) confirm that, as a group, institutional investors continue to allocate to hedge funds despite what the headlines would have you believe.

Net asset flows (US$M) to hedge funds, 2006 to 2016

net-asset-flows-in-usm-to-hedge-funds-2006-to-2016

net-asset-flows-in-usm-to-hedge-funds-2006-to-2016

Source: Alternative Investment Management Association (AIMA) and HFR.

The role of hedge funds

So what role were hedge funds expected to play in a portfolio context? Did investors expect them to have a negative correlation to equities all the time (to decrease their equity risk), or did they want a highly concentrated equity manager that increased their exposure to equities? It is important to have this well framed at the outset and to understand the associated costs.

If an investor wants a fund that is guaranteed to produce positive returns during equity down markets, are they willing to sacrifice option premium any time the market advances? The benefits we expect from hedge funds include capital preservation, lack of equity correlation during difficult market events and access to otherwise unavailable return streams.

We often see a direct comparison of returns between hedge funds and equities, normally with a headline along the lines of ‘equities outperform hedge funds’, but never the reverse. This of course could be true at any time, but does it really matter? It is worth bearing in mind that hedge funds invest across many different asset classes and target exposure levels that are quite different to equity indexes, so comparing them to any single asset doesn’t make much sense, even though it does make a good headline.

Direct comparisons also fail to take into account the different types of risks inherent in each investment. You rarely read extended stories about equities outperforming bonds, for instance, because most people understand that the risks involved in each are quite different, so it makes little sense to compare them. To this point, I find it surprising that a large number of investors think that hedge funds in aggregate are riskier than equities even though any research I have seen would point to a well-managed portfolio of hedge funds being substantially less risky than equities (in terms of capital preservation and volatility).

While we think of risk as multi-faceted, highly subjective and impossible to reduce to a single number, for the purposes of this study we’ll use volatility as a risk proxy because it has gained wide support from investors. On this basis, since 2009 we have seen a decrease in the volatility of most hedge fund returns and current levels are 20% below the average of the past 15 years. Equities on the other hand are currently running at volatility levels approximately 20% above the average for the same time period.

Additionally, hedge funds in aggregate display a far lower level of volatility than equities due to their active risk management. The graph below shows the significantly lower volatility of the hedge fund composite index than the main equity index.

Annualised volatility of hedge funds, S&P500 and global bonds.

annualised-volatility-of-hedge-funds-sp500-and-global-bonds

Source: AIMA Research

There is a widely held but largely incorrect view that, due to the use of techniques such as shorting and leverage, hedge funds are riskier than traditional long-only equities. These techniques create different risks, but that doesn’t necessarily make hedge funds any riskier. There may be individual funds that are riskier than equities, but the vast majority of hedge funds use these techniques to reduce, not increase their risk. Of course, the results will vary among managers due to their skill in applying the techniques, but in aggregate hedge funds are substantially less risky than equities using almost any commonly accepted measure of risk.

US stocks have outperformed hedge funds in recent years, but longer-term performance going back decades shows hedge funds delivering significant outperformance, especially on a volatility-adjusted basis. At certain times, it is normal for hedge funds to underperform equities, but over time their ability to protect capital during tough times can result in their outperformance. We continue to believe that investors and financial advisers should consider the role and benefits that hedge funds can play in a diversified investment portfolio.

 

Craig Stanford is Head of Alternative Investments with Morningstar Investment Management Australia Limited and Chairs the Investor Education Committee for AIMA in Australia. This material has been prepared for educational purposes only, without reference to your objectives, financial situation or needs. You should seek your own financial advice.

4 Comments
Rob
September 17, 2016

Hi Just read the article on the merits of hedge funds - the first bit of common sense I've read on this topic in years, great article, thanks. How do sophisticated investors get access to hedge funds, where can we go to compare the investment styles of different managers so that an investment decision can be made? I have found that hedge funds are just not on the radar of my traditional advisors (probably because they stand to gain no fees from any allocation made to them). Kind regards Rob

SMSF Trustee
September 18, 2016

Rob, my SMSF uses a couple which I access via the AMP North investment platform that I use. Which, by the way, my 'traditional' advisor put me on to.

Don't know how you get access without a platform that includes them.

(Editor's note: Most major platforms from the large retail funds include a range of 'alternative' options).

Warren Bird
September 16, 2016

Institutions that use such vehicles tend not to call them 'hedge funds'. The word 'alternatives' is more common, in the sense that Jerome has in mind, viz that they are an alternative way of engaging with markets than only being long in a range of asset classes.

One issue is that, unlike the traditional asset classes - "equities" or "bonds" or "property" - the alternatives space has no underlying return that is available to all investors as the heart of the return. Long equities gives you the return of the market plus or minus the manager's contribution minus fees. Going into alternatives only gives you the manager's contribution minus fees.

If you think the underlying market return is going to be negative, then taking that element out of the equation makes sense. However, going into alternatives creates the potential for a much wider disparity of outcomes, depending on which managers/funds you use. In turn, this requires a lot more work upfront in understanding each fund's style, resourcing, risk management, etc. The moreso since the sector tends to think itself so much better than anyone else that it charges very large fees, which are always a minus element in the equation.

The same can be said for other alternatives such as private equity. Getting the right fund is crucial. The bad performers in these areas are really bad.

I don't think this can be lightly dismissed. You can't just shrug your shoulders and say 'naturally, there will be disappointments'. The sector doesn't sell itself as having as much downside risk as actually exists for getting it wrong. And the costs of exiting once you decide that you made a wrong choice can be horrendous.

As a sector, alternatives/hedge funds are worthy of consideration. But I agree with Jerome about the importance of being selective. Being skeptical about the performance claims of many in this sector is also important - they tend to talk a great story!

Jerome Lander
September 15, 2016

It is hard to imagine a better time to use hedge funds than the present given the economic backdrop and risks to mainstream long only investing!
Naturally, there will be disappointments and this is a space - like all other opportunities - where having an open mind and being selective is essential.
Anyway, need to go back to looking for more good hedge funds....

 

Leave a Comment:

     

RELATED ARTICLES

What role should hedge funds play now?

‘Super-defensive equities’ may rescue struggling 60/40 portfolios

The long and short of hedge funds, Part 2

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.