Hedge funds: Be afraid of those definitions

Date: Saturday, October 13, 2007
Author: Sean Kelleher, Gulfnews.com

"Be afraid, very afraid," says Howard Smith, CEO at QIM asset managers. It's not the man in the hooded cloak and dagger that's getting to him, it's the gay abandon being applied to the definition of what a hedge fund is. Time to reflect.

Since the Merrill Lynch Capgemini World Wealth Report correctly predicted the surge of hedge funds within HNW portfolios, hedge funds have become an increasingly "mainstream" tool as a means of mixing into portfolios with a view to maintaining good (not brilliant) performance, but, with the principal benefit of reduced risk. More specifically, reduced downside standard deviation.

Cloak and dagger

So what's so cloak and dagger about that? Two quotes highlight Smith's consternation.

The first from The New Statesman: "If hedge funds were a country, it would be the eighth-biggest on the planet. They can sink whole economies, and have the potential to crash the entire global financial system. Yet they are beyond regulation. We should be very afraid."

So Smith is afraid, very afraid. Afraid because such an analysis doesn't seem to apply to the instruments being used to reduce risk. The problem lies in what The New Statesman defines what a hedge fund is. There's more.

Dr Ben Bernanke, chairman of the US Federal Reserve, the most important financial supervisor of all, was quizzed by the US Senate Banking Committee about whether derivatives - complex financial instruments liberally used by these hedge funds - should be regulated.

He commented: "Derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and use them properly."

Yes, be afraid, very afraid. These instruments are not only used by sophisticated financial institutions but are a considerable component of most self-respecting pensions, managed funds, and a host of other vehicles used by the men and women of the street.

Hedge funds/ Alternative Investment Strategies (AIS), or whatever you want to call them; stopped being an elitist tool some time ago. Regulators wake up.

No more elitist

Clearly, there is a need to define what hedge funds are so that we know what it is we should be afraid of. So two bits to the substance of this week: part one, be afraid of definitions. Part two; let the index do the talking.

Part One: Howard Smith has gone on the internet to reap a host of weird and wonderful "hedge fund definitions". They range from the bizarre to the more bizarre. See the box, and note the Howard Smith definition which more closely approximates to UAE market experience of what is commonly sold at "mainstream" level.

Part two takes us into the issue of how well have they done. Looking at the CSFB Tremont index over ten years they seem to have done well compared to the World MSCI index.

That may not appear a fair comparison because of the bear market in equities from 2000 to 2003 but even looking at the shorter term.

The clear message is the underlining of Howard Smith's definition: that hedge funds seek to achieve consistent returns with very low volatility.

So why the press frenzy over "sub-prime" and hedge funds? The table below is made up of the overall Credit Suisse Tremont Index, with some specific hedge fund strategies.

Clearly, returns from the individual strategies vary. As Smith says; "You would expect this because, say, event driven depends on something happening. Sometime nothing happens".

Looking at the table there doesn't appear to be any disasters. Is the sub-prime/hedge press comment overdone?

According to Smith, the answer is yes and no. There have been some spectacular "hedge fund" failures especially in the structured debt markets.

Typically these funds bought the low quality portion of the mortgage debt known as "subprime" in order to boost the returns of this statistically safe investment, the funds who sold it leveraged (or geared) three times.

Forced sales

Whilst it is not yet true that the value of the investment fell by a third the need to meet increased margin calls forced sales of assets which killed the funds.

"This happened several times and involved the loss of several billions of dollars," says Smith.

So, is this a hedge fund issue?

According to Smith: "No. Along with funds that invest in the stock market with the ability to sell short the investment community has labelled them as "hedge" and they behave like some of the more bizarre hedge fund definitions" says Smith.

Clearly in the early 2000s hedge funds looked like a great way to make money when stock markets fell.

This has encouraged fund managers, bankers and intermediaries to feed the investing public with high risk volatile funds which have always been the easy sale when things are going well. Be afraid, very afraid of that.

The writer is chairman of Mondial Financial Partners International.

Hedge funds: What are they?

Here are some of the recent definitions of hedge funds:

- Speculative funds managing investments for private investors.

- Hedge funds are speculative funds which make large bets on market movements. They utilise borrowed money to substantially leverage their returns (and losses), often at a factor of ten to one, or more.

- Vary greatly, but have some or all of the following characteristics. They will be based offshore and are virtually unregulated. They will have small groups of investors, usually rich individuals or institutions.

- A fund which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, programme trading, swaps, arbitrage and derivatives.

- Investment vehicles that attempt to make above-average returns. Often bet on currency markets or mergers and takeovers. They borrow heavily sometimes to double their bets.

- Funds which have the ability to "gear" portfolios by borrowing to increase their exposure to underlying stock markets. This method increases risk as well as the potential for gain.

- These are funds usually used by wealthy private investors or institutions. Hedge funds are restricted by law to no more than 100 investors; the minimum contribution is typically $1 million!

A more sensible definition might be: A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees gains at reduced risk. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

Source: Howard Smith, QIM Asset Managers