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| Special Report – Hedge Fund Questions and Answers |
Hedge funds have received significant, albeit mostly negative, attention over the past
week in the aftermath of troubles with Amaranth Advisors, a large multi-strategy fund
that recently lost most of its assets. Given the high profile nature of the Amaranth
situation, Hewitt Investment Group (HIG) thought it would be an ideal time to address
questions and provide our insights regarding hedge fund investing. We hope that by
sharing our thoughts, clients may better understand an often opaque and misunderstood
segment of the investment industry.
HIG has researched the hedge fund industry thoroughly over the past 10 years.
Over the past decade, we have developed a fairly systematic approach to
reviewing hedge funds, focusing foremost on business, strategy and qualitative
risks. Our cautious (and often somewhat skeptical) approach has served clients
well in a variety of markets.
The following attachment provides the following questions and answers:
If you have any questions or would like to discuss these topics in more detail,
please contact Mike Scotto, HIG's Director of Alternatives Research, at (203) 852-1100.
What are hedge funds?
The term “hedge fund” refers more to a legal structure than any one type of
investment. Hedge funds, like mutual funds, can generally invest in any asset class or
multiple asset classes. Characteristics of hedge fund structures include:
- They are usually private investment vehicles;
- Charge a management plus incentive fee;
- May (but not always) use leverage;
- May use short selling and hedging techniques;
- Typically pursue absolute return performance target rather than market benchmark; and
- Fund and/or fund manager may or may not be registered with the SEC.
What purpose do hedge funds serve within institutional portfolios?
Hedge funds can serve multiple purposes within institutional portfolios.
In general, investors look to hedge funds for two main reasons: to add
return relative to public markets (equity and fixed-income) and to reduce
risk. Based on our experience, we have found that many hedge funds can indeed
lower overall portfolio risk (when measured by return volatility) for most
institutional investors. Hedge funds serve as a diversifying element within
an investment program due to their low correlation with other assets such
as public equities and traditional fixed-income. Put more simply, hedge funds
invest in different asset classes than traditional investment managers and may
also have short exposure (bets against market direction) and these aspects each
add diversification.
A second group of investors look to hedge funds to achieve returns in
excess of those obtainable in public markets (common stocks and mutual
funds). Our research has shown that, over long time periods, hedge funds
outperform fixed-income investments but have a hard time outperforming
traditional equities on an unlevered basis. Therefore investors seeking
to outperform equity markets must invariably look to hedge funds that use
leverage. Although seemingly straightforward, this concept is often
misunderstood by investors. For example, many equity hedge funds are
unlevered and/or unhedged; thus expecting equity market beating returns
from such funds is not realistic, especially given the high fee structure
(e.g., 1% to 2% management fees and 20% incentive fee) associated with
hedge funds. Unless an investor is comfortable with the use of leverage
and understands its role in a manager's strategy, expecting a hedge fund
to beat the equity market is often a low percentage bet.
How risky are hedge funds?
Hedge funds each have unique risks and each fund must be assessed based
on its own merits. Some firms offer strategies and business models that
are highly stable, others may have higher risk business models and strategies.
During the course of our due diligence work, we group risks into two
categories: organizational/business risk and investment risk.
Typical organizational/business risks include items such as:
- The size of the firm (smaller firms have greater business risk);
- Whether the firm is registered with investment authorities;
- Internal control procedures;
- Whether the firm has appropriate liability insurance; and
- Depth of staff.
Strategy risks may include items such as:
- Large position sizes;
- High use of leverage;
- Lack of pricing/illiquidity of assets; and
- Lack of transparency.
A thorough due diligence process can usually determine risks in each
of these categories. In our experience, both strategy and
organizational risks need to be considered in tandem.
Why do hedge funds fail?
In a largely unregulated industry, hedge funds have more freedom to operate
and more room to fail relative to traditional investments such as mutual
funds. Hedge funds generally fail for several reasons:
Fraud. Due to lack of transparency and regulation there is a risk
of fraud within the hedge fund sector. A well conceived fraud is virtually
impossible to detect, at least initially, by outsiders.
Weak businesses. Many smaller funds fail due to poor/unstable
economics. Smaller asset bases coupled with a year or two of weak returns
can create cash flow problems for smaller funds. Large funds can also have
problems if there is a mismatch between investor liquidity terms and the
liquidity of a fund's underlying investments.
Leverage. Leverage is a tool used by many hedge funds. However,
when overused, leverage can cause severe drawdowns. Long Term Capital
Management failed due to excessive leveraging of low volatility trades.
Amaranth Advisors likely failed due to leverage applied to volatile
investments.
What are the key red flags?
The hedge funds we have favored over the years generally exhibit well
defined and disciplined investment strategies and organizations.
Red flags to watch out for include:
- Departures of key staff;
- Change in investment approach;
- Dramatic change in return profile (returns not consistent with peers or strategy); and
- Dishonesty, i.e., investments in the fund that are not in keeping with those described by the manager.
Our outlook for the future?
In our view, hedge funds may make sense for clients seeking to dampen
volatility within their portfolios. We approach each client on a
customized basis and therefore hedge funds may not be appropriate for
every client. In the past, crisis periods within the hedge fund
industry (e.g., the Long Term Capital Management crisis) have led to
heightened due diligence practices amongst alternative investment
professionals. This is always a good outcome for the industry. There
will also always remain a segment of the hedge fund and consulting
industry that chases returns and the latest “hot” manager
(sector, etc.) in an attempt to beat the equity markets; as we have
seen from the events of this past week that approach is not without a
sometimes costly downside.
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