What do George Soros, Jim Rogers, Steven Cohen, and Myron Scholes have in common? They all ran hedge funds. Three of them have made huge fortunes for their investors and themselves, and one is a Nobel laureate . If hedge funds were good for them, are they good for you?
First, let me answer this question as it relates to me. Most of the ''managed money'' in my own portfolio is in hedge funds, and in long/ short equity positions in particular. I actually prefer to call them non-traditional funds, because in reality they are extensions of what mutual funds can do. The managers can take their stocks long or short, use a very moderate degree of leverage, or invest in derivatives.
I tend to shy away from funds that use derivatives for speculating, preferring those that use options for reducing risk. More specifically, much of my personal managed money is in equity long/short funds structured amazingly close to the original model created by Alfred Winslow Jones.
One respected manager who runs both mutual and hedge funds said to me recently: "I just feel safer in my hedge fund because the short positions give me some insurance if the world goes to hell in a handbasket."
When it comes to institutions, pension funds, generally speaking, have been taught by consultants to do in-depth quantitative analysis of money managers. These money managers have to fit into a tight box what they can and cannot do. This often means they are afraid to make any substantial mistakes.
So what will they do? Hug the index, of course.
Ah, but institutions aren't dumb. "Hey, we are not going to pay you fees unless you beat the index, risk-adjusted or not," they say. "We will just buy ETFs instead."
So far, it makes sense, but here is the kicker: Institutions (and most other investors) don't want a money manager to stray too far from the index, because that is risky. At the same time, they want the managers to beat the index. The two scenarios can't co-exist.
There's also the issue of many Canadian pension funds being underfunded, meaning there's not enough money to meet their obligations to pensioners. The more underfunded a fund is, the more it won't want to take a risk by putting a non-traditional manager in the portfolio.
The result is that it is more difficult these days for an excellent long/short equity manager (or any non-traditional manager) to get allocations from Canadian institutional accounts. But institutions are the exact group that should be looking for the possible alpha of hedge funds.
As for retail clients, most want one thing: relative returns, or beating the index, in up markets, and absolute returns (always positive) in down markets. Risk-adjusted returns, correlation, and strategic asset allocation are usually way over their heads. All they know is, "I got my statement and my fund went down this month."
The response from the hedge fund manager usually goes like this: "Well, that's because we were short financials because we think there is a risk in that sector. The rally in financials was just a 'dead cat bounce,' caused by a massive amount of short covering." To this, the response from retail investors, who generally have little understanding of the investment strategies being used, sounds a lot like this: "Um … OK, but the market went up and my fund went down, so I am unhappy this month."
While interviewing the best hedge fund managers in the country over time, I have learned a few things. Their portfolios never look like an index, and they don't really care about the index. They usually own their own little shop, as working for a big fund company is often too constraining to "think outside the box."
So, in answering the question of whether hedge funds are for you, consider the following: your appetite for risk, your ability to accept a period of negative returns, and whether you can withstand getting too excited about that "dead cat bounce." - Bob Thompson is an associate portfolio manager and alternative investment strategist at Canaccord Capital. Mr. Thompson and his team man-age hedge fund portfolios for high net worth individuals. He can be reached atbob_thompson@canaccord.com.
