Use hedge funds to reduce risk, not boost returns, cautions Merrill Lynch

Date: Monday, June 25, 2007
Author: James Langton, Investment Executive

Investors should choose hedge funds that invest in markets and strategies not included in their existing portfolio.

Hedge funds still have their use for investors, but they have probably underestimated the funds’ risks, says Merrill Lynch in a research note.

“We continue to believe that hedge funds are a viable asset class that, if chosen properly, can provide diversification within an overall portfolio,” it says. “We reiterate that diversification is a risk-reduction tool, and not a return-enhancement tool. Those who are lured to hedge funds simply because of historical performance are likely to be disappointed.”

Therefore, it counsels investors to look for hedge funds that invest in markets and strategies not included in their existing portfolio. “For example, someone with significant exposure to technology stocks probably should not be looking at a hedge fund that specializes in technology shares for diversification purposes.”

Despite their use as a diversification tool, Merrill says that hedge funds’ correlations to other asset classes have gone up during the decade. The notion that hedge funds are “uncorrelated” is not nearly as true as it was early in the decade, it says.

It enumerates several other the emerging concerns with hedge funds. “According to the Financial Times, there are now nearly 10,000 hedge funds worldwide. We would caution that many of them have not demonstrated that the managers possess exceptional skill. Yet, it is difficult for investors to determine
who is a good manager because most funds are too new for a representative track record (a warning sign itself!), and reporting data are not yet transparent enough so that easy comparisons can be made across funds,” it says.

A lack of transparency is, “especially important when one considers that investors still do not seem to fully understand that investing with extreme leverage is a double-edged sword,” it says. “We have found it odd that investors have indiscriminately flowed into this asset class without fully investigating how leverage is being used, the cost of that leverage, and the influence that such leverage can have on positive and negative returns. After all, isn’t there something amiss when a fund is levered 10-20 times and provides returns only slightly better than those of a stock index fund?”

Also, it observes that many investors do not understand that hedge funds are effectively unregulated banks. “As such, their success may be at odds with global central banks’ attempts to control money supplies and inflation expectations. We continue to believe that global monetary policies will be secularly tighter than investors currently expect as central banks attempt to disintermediate the hedge fund community,” it says.

“Overall, hedge funds remain a viable asset class. Unfortunately, as the rash of headlines shows, investors have probably significantly under-estimated the risks of the asset class,” it concludes.