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Hedge Funds Offer Nothing New Except Opportunities: Analyst

Date: Friday, June 7, 2002

(June 7, 2002) While high net worth investors in Canada have embraced hedge funds with alacrity, pension funds remain reluctant. The allocations are still very low, says Wendy Brodkin, president of Goodman & Company Institutional Investments, which she puts down to a series of expectations gaps. But pension plans also have no incentive to innovate, she adds. Brodkin, speaking at a hedge fund conference sponsored by the Strategy Institute at Mont Tremblant, Quebec, enumerated a number of gaps. Pension funds are unsure about whether hedge funds engage accounting tricks or assume inordinate risk. In many cases, hedge funds are not very transparent about their holdings, which sounds an alarm bell for pension fund managers. But many of these gaps are the result of unrealistic expectations on the part of pensions funds clinging to a traditional outlook. They're seeking asset safety and assume that since few of the top institutional money managers offer alternative investment strategies, they aren't worth looking into. "If Jarislowsky Fraser isn't doing this, it can't be any good," noted Brodkin. Another gap derives from the fact that hedge fund managers "don't act like regular managers anyway." These expectations gaps are reinforced by an unwillingness on the part of many pension funds to learn more about alternative strategies. All that sets up a real hurdle for pension funds that face faltering returns from traditional equity and bond strategies. "The biggest challenge is getting 96% of North American pension funds to put money in" alternative strategies, she said, since only about 4% currently have put money in, some of them as much as 20%. Part of the problem, says Thomas Schneeweiss, the Michael and Cheryl Phillip professor of finance at the University of Massachusetts and a prominent academic analyst of hedge funds, is that the investment landscape has changed "dramatically" over the last 30 years, but the road maps haven't, giving little direction of how to work in unique investment environments. But alternative asset managers have to communicate the changed map and the opportunities for finding returns, or alpha. "If we don't," Schneeweiss says, "we'll be out of a job." The old investment maps deal with traditional asset classes, but "traditional stock and bond markets are not becoming the primary means by which investors can find alpha opportunities." The alpha opportunities aren't all that new, however. Hedge funds use a variety of strategies and Schneeweiss prefers to call hedge funds strategies rather than an asset class. "There's not a single [hedge fund] strategy that has not been traded on the proprietary desks of major banks over the past 15 to 20 years," he said. "Hedge funds are nothing more than the privatization of the proprietary desk." As a result, hedge fund strategies can be reasonably predictable in their outcomes. The question becomes "do you make your money where you should" by following the strategy? "I'm looking for hedge funds to make money in exactly those kinds of markets where they're supposed to," Schneeweiss said. Hedge funds, like many other non-traditional investments, come in two forms. Either they enhance returns when applied alongside traditional strategies, or they diversify risk, softening the losses when traditional strategies go south. But the same type of analysis applies to each. "There's nothing we do in the alternative arena that we don't to in the traditional arena," Schneeweiss said. "There's nothing on today's map where we don't understand the sources of return." Identifying and then correlating the sources of return is key to adding alternative investment strategies to a portfolio. But, Schneeweiss said, "if hedge funds don't offer you something unique from traditional ones, you shouldn't be there... each one of these strategies has a unique opportunity and unique sources of return." Some of the returns stem from the fact that hedge fund managers aren't constrained by institutional rules. "Hedge funds provide diversification traditional investments simply don't," he added. But, as against the myth of hedge fund wizards with strategies encased in a black box, Schneeweiss pointed out, "It's actually the same world as traditional investments." The repertoire of instruments is bigger, however, with hedge fund managers able to sell stocks and other securities short. They load on the same factors as traditional strategies; in other words, multi-factor analysis shows that they draw returns from the same sources as traditional investments. As a result, particular strategies will show high correlation with some traditional strategies. But the pattern of returns will depend on manager skill. Those differing patterns permit a different sort of asset allocation, one where the same level of returns can be achieved but with lesser risk, or where higher returns can be achieved, but with a similar level of risk. Equity hedge funds, which are often a play on tech stocks on the Russell 2000, can produce higher returns when added to a portfolio, but at the same volatility. By contrast, relative value strategies, which usually involve arbitrage between similar securities, can provide similar returns at reduced risk. Given the performance characteristics of hedge fund strategies against the backdrop of flat traditional markets, the real question Schneeweiss believes is "what do I take out?" Should the fixed-income component be trimmed to make room for relative value strategies, or should the equity component be split among passive index investments and active hedge fund managers who can generate returns in excess of the benchmark? At the end of the day, Schneeweiss said, hedge funds expose themselves to the same risks as traditional investments. The difference is they can provide the alpha, or excess returns that traditional strategies aren't.