Expecting too much from hedge funds

Date: Thursday, November 2, 2006
Author: FT Mandate

The massive losses suffered by Amaranth Advisors, coupled with the remarkable fall from grace of Vega Asset Management, has forced investors to focus hard on the risks associated with hedge fund investment.

The Amaranth debacle begs a number of obvious questions: Why did a $10bn diversified multi-strategy fund allow one 32-year-old trader to make a highly-leveraged bet on a single position (natural gas futures) and proceed to lose $6bn in a month?

Were the investors aware that one trader was handling such responsibility? If not, why not? Certainly, they will never again rest easy in the belief that a financial product “does exactly what it says on the tin”. A similar case of seemingly blind trust in a certain young derivatives trader led to the collapse of Barings Bank in 1995 under the weight of losses totalling $1.3bn.

Clearly, the lesson was lost on some in the financial services industry. Or maybe only among the alternative investment community whose collective memory of previous hedge fund blow-ups appears to be less reliable than that of the investors they are trying to woo.

While sceptical institutional investors frequently raise the spectre of Long Term Capital Management eight years after it went belly-up with losses of $4.6bn, hedge fund managers are quick to dismiss the fund’s leverage-fuelled demise as ancient history.

The slump at Spanish-based Vega has prompted industry observers to ask whether the hedge fund had become a victim of its own asset-gathering success. A reported fivefold increase in assets under management in less than two years – peaking at $10.1bn in 2004 – was followed by negative performance which precipitated withdrawals of capital by investors.

The question of how big is too big is becoming more pertinent as the hedge funds attract increasing amounts of institutional money.

Good returns will be harder to come by as a swelling tide of cash comes up against unyielding capacity constraints. And it is not only the investors in Vega who are disappointed with their investment returns. According to global research by Mercer Investment Consulting, less than a quarter of pension schemes that invest in funds of hedge funds are satisfied with performance.

Divyesh Hindocha, global head of investment consulting at Mercer put this lack of satisfaction down to a mixture of high expectations and fund managers not explaining their strategies clearly enough. He said pension schemes were unclear about their investment objectives and what the hedge funds could realistically deliver.

The survey also found that just 58 per cent of respondents overall understand their funds of hedge fund manager’s approach. In Europe, only a third of schemes said they understand.

Mr Hindocha said that investors want to gain a better understanding of a fund’s strategy and operations, but that many investment managers are reluctant to disclose full details.

Sixty per cent of schemes which did not currently invest in funds of hedge funds, cited fees as the greatest barrier.

These findings point to the need to step up efforts to educate potential hedge fund investors. It might not be in the interest of the hedge fund manager’s sales director to say it, but someone should tell potential subscribers about the performance-dampening effect of too much money chasing a few popular hedge fund strategies.

But as this column has observed on more than one occasion, since the turn of the millennium, investment conferences around the world have staged talks and seminars on hedge funds. And every year, these presentations are pitched at the most elementary level suggesting that asset managers are struggling to get their message across. Maybe its a case that institutional investors themselves are not paying enough attention.

Despite the education deficit, recent reports point to growing institutional demand for hedge funds. Greenwich Associates said the proportion of continental European institutions identifying themselves as hedge fund investors increased from 26 per cent in 2005 to 35 per cent in 2006, while another 10 per cent say they have plans to begin investing in hedge funds in the coming months. However, the research shows that at 2 per cent of total assets, allocations to hedge funds (and private equity) haven’t budged.

A new study from the Bank of New York says that global institutional demand for hedge funds will increase from $360bn currently to more than $1000bn by 2010. By then, nearly 25 per cent of institutions will be investing in hedge funds.

If they are to do so safely and profitably, investors must start asking more searching questions of hedge fund managers. They must focus as strongly on risk profile and risk control mechanisms as they do on investment process. In the wake of Amaranth, asset managers have been quick to stress the importance of a meticulous due diligence process. They are right; investors can never be too scrupulous when selecting managers. If F&C can comment that “Amaranth had some of the best risk management and systems” it truly is a case of buyer beware.

Henry Smith, editor