Hedging his bets on performance

Date: Monday, November 13, 2006
Author: Jonathan Chevreau, Financial Post

But other advisors more cautious on hedge fund liability

According to hedge fund aficionado Miklos Nagy, hedge funds have a place in client portfolios -- but if it's anything less than a 10% weighting, "you may as well not bother."

That recommendation seems to me a tactical error, since in my experience most financial advisors prefer to dip their clients' toes into new asset classes or products gently: perhaps a 5% "starter position" or even less.

Nagy is the co-author of Hedge Funds for Canadians and president of a hedge fund company called Quadrexx Asset Management. At last week's World Hedge Funds Summit, he gave a presentation on why financial planners should recommend hedge funds for their clients.

We'll recap Nagy's arguments here, then turn to other sources that will help advisors complete their due diligence on this intriguing asset class. The first question Nagy tackled was whether hedge funds should replace stocks, bonds or both.

"If you buy 10 different hedge funds, some believe the portfolio will behave more like a bond in terms of risk than equities, but some believe hedge funds are more like equities," Nagy said. He suggests advisors make room by reducing the weighting of both.

Nagy invokes such familiar arguments as diversification, lack of correlation with other major investments, performance and the sheer growing popularity of hedge funds.

Thus, worldwide, hedge fund assets under management have soared from US$200-billion in 1995 to US$1.34-trillion by September, 2006. Furthermore, the industry has just come off a record US$44.5-billion in sales in the third quarter. Hedge fund of funds make up more than a third of the industry and are growing at 40% a year.

Personally, I'm not so sure the fact the "herd" is jumping into hedge funds is a plus. Mutual fund investors are notorious for "chasing performance" and dumping money into asset classes that are topping out: tech funds in early 2000, for example, or emerging markets in 1993 or more recently.

So has hedge fund performance been worth chasing? Nagy thinks so. He quotes a recent Mercer study of institutional hedge fund users, who expect a return of 4% to 6% above the risk-free treasury bills, net of fees. Those "bond-like" returns are actually modest compared to the double-digit returns the industry used to brag about.

Still, Nagy says returns of hedge funds globally are 2% better than the major stock indices and achieve this with half the volatility. Between 1987 and 2005, the Hennessee Hedge Fund Index had a 13.7% annual return while the S&P 500 returned only 11.6% and with higher volatility.

In bull markets, hedge funds do about the same as regular equity indexes but in bear markets hedge funds really shine, Nagy believes.

His other argument is that hedge funds have a low correlation (around 0.27) to the S&P500, although a higher (0.74) correlation to the TSX composite.

Admittedly, the correlation argument has some appeal, since it's the main reason for holding alternative investments in diversified portfolios.

But there's more than one way for advisors to skin that cat. Before simply selling clients hedge funds on the say-so of hedge fund executives, advisors would be well advised to read some dissenting opinion.

There are currently two excellent books that survey a wide swath of alternative investments, including hedge funds. One is by David Swensen, better known as the chief investment officer for Yale University's Endowment Fund. In that position, Swensen is responsible for putting some of that institutional money into hedge funds.

However, in his book, Unconventional Success [Free Press, August 2005], Swensen is far less enthusiastic about hedge funds for retail investors, just as he is also skeptical about actively managed mutual funds.

A more current book, not available yet, is by Larry Swedroe, author of an indexing treatise titled What Wall Street Doesn't Want You to Know. He's about to publish The Only Guide to a Winning Strategy For Alternative Investments You'll Ever Need. Subtitled The Way Smart Money Diversifies Risk Today, it's cowritten with Jared Kitzer.

Like Swensen, Swedroe reviews the many core and non-core investments available to retail investors. Both, for example, like U.S. and international stocks or ETFs, inflation-linked bonds and real estate or Real Estate Investment Trusts (REITs).

Swedroe breaks the world of alternative investments into four groups: the good, the flawed, the bad and the ugly. In the "ugly" he includes variable annuities.

He places hedge funds in the "bad" category (albeit one step up from "ugly.") Swedroe says the main selling point of hedge funds is "their supposedly superior performance." His data suggests this is lacking. In contrast to the longer-term numbers used by Nagy, Swedroe says that in 2003 the average hedge fund underperformed the various equity asset classes by from 15.3% to as much as 65%. In 2004, they underperformed by from 13.6% to as much as 35.9%.

David Swensen also questions the performance data tossed around by hedge fund sales people. He says it shares the same problem of "survivorship bias" that plagues mutual funds. Thus, the industry tends to kill or merge poor performing funds and bury the track record.

An example is the famous implosion of Long Term Capital Management in 1998. Swensen notes that while LTCM's early spectacular track record inflated the industry's aggregate results, its subsequent staggering losses "appears nowhere in Tremont's treasure trove of data."

He says Tremont (maker of one of the popular hedge fund indexes) reported 32.4% a year for LTCM when in fact its actual record was minus 27%. Swensen describes this as "a staggering gap between perception and reality ... that fundamentally misleads investors regarding the true character of hedge fund investing."

At the conference, Sandra Manske of Maxam Capital Management questioned this until I showed her the relevant passage in the book (in a section on Survivorship Bias). Manzke also gave a presentation on hedge fund indexing, which is harder than it appears because many hedge funds are as reluctant to provide performance data as they are information about their holdings. Many hedge funds are slow to send in their numbers when they are lagging, she said.

The point remains, however. Any advisor recommending clients move significant (and I'd call 10% significant) portions of client portfolios to hedge funds need to satisfy themselves that all industry performance claims can be verified.

www.nationalpost.com/chevreau