Hedge Funds: Clipped

Date: Thursday, March 5, 2009
Author: Jeremy Hetherington-Gore

Hedge funds lost a record 21.44% in 2008 according to the Barclay Hedge Fund Index compiled by BarclayHedge. “2008 hedge fund losses were widespread, with 70% of the funds that report to us ending the year in the red,” says Sol Waksman, founder and president of BarclayHedge. "Managers of funds of hedge funds turned in an even poorer performance, with 85% finishing in the minus column, losing an average of 21.69%.” 

It has been estimated in a new report that total hedge fund assets at the end of 2008 stood at USD1.43 trillion, a decline of over USD700bn or 34% from 2007 levels.

According to Crédit Agricole Structured Asset Management's (CASAM) 2008 Industry Report on hedge funds and commodity trading advisors (CTAs), the total number of hedge funds is estimated to have declined from over 9,700 at the end of 2007 to around 8,900 today.

However the beginning of 2009 showed what may be the start of a recovery. Hedge funds as measured by both the Greenwich Global Hedge Fund Index (GGHFI) and the Greenwich Composite Investable Index (GI2) withstood falling equity markets during the month of January to begin 2009 with gains.

The GGHFI and GI2 returned 0.42% and 0.10% during the month, respectively, compared to global equity returns in the S&P 500 Total Return (- 8.43%), MSCI World Equity (-8.85%), and FTSE 100 (-6.42%). 59% of constituent funds in the GGHFI ended the month with gains.

"January was an excellent start to 2009 for hedge funds despite a challenging environment in most equity markets. Three of four hedge fund strategy groups ended the month with gains while global bourses on average shed 6-10%. The value of hedge funds in mitigating severe losses has never more evident than in the start of 2009," notes Margaret Gilbert, Managing Director of Greenwich Alternative Investments, which compiles one of the oldest hedge fund performance benchmarks.

The it was announced on February 10 that the Credit Suisse/Tremont Hedge Fund Index increased by an estimated 0.8% in the month of January.

"Faced with a barrage of weak corporate earnings and macro data in January, the economic stimulus package was at the top of the agenda for the incoming Obama administration. The US Federal Reserve acquired USD53bn of mortgage-backed securities in the month of January as it continued its efforts to shore up the credit markets, while the UK, Europe and Japan also implemented similar measures," Credit Suisse/Tremont observed in the announcement.

After the annus miserabilis of 2007, which saw such world-scale disasters for the hedge-fund sector as the demise of Amaranth, hedge funds had delivered a fairly unremarkable performance in the first half of 2008, so it was all the more shocking that they fell out of bed with such a bump towards the end of the year.

In fact, hedge funds have outperformed US stock markets in seven of the past 12 years, three of which were in the bear market of 2000 to 2002, according to Sol Waksman, founder and president of Barclay Hedge. “In up years, stocks usually outperform the hedge fund industry as a whole, since hedge funds include both long and short strategies, whereas stock indexes are always 100% long," he noted.

So what's the truth of it? Do a couple of stable months mean that the industry has grown up? Have we seen the last of the good times of 20-40% returns? Are hedge funds heroes or villains?

Well, it's a lot easier to ask the questions than it is to answer them; and it is not even safe to try. What we can do, though, is to point to some of the basic features of hedge funds, which won't change overnight, and suggest some precautions to take before jumping head first into (or clambering expensively out of) what is a very complex and diverse investment sector.

What is a hedge fund?

From the amount of speculation and debate that has surrounded hedge fund investment in recent times, you could be forgiven for thinking that hedge funds were a relatively new development in the investment world. However, you would be wrong.

The first fund to be dubbed a 'hedge' fund was the A.W. Jones Group in 1949. The fund derived its nickname from its strategy of taking long and short positions in the stock of companies (a strategy which continues to be central to many hedge fund managers, and which will be explained in greater detail in the next section). This meant that it could hedge against macro-economic factors, while at the same time benefiting from the individual performance of specific companies.

Hedge funds offer the potential for attractive returns, and are a lot more nimble than traditional mutual funds or other investment structures, which makes them an especially suitable option in volatile or falling markets. Until recently, they required high minimum investments (many still do), and until very recently, were only allowed to accept 'accredited', or 'qualified' investors.

It has only been in the last ten to fifteen years that the industry has really taken off. According to estimates, in 1990 there were as few as 300 hedge funds in existence. However, by the year 2000, this number had multiplied to over 3,000 funds controlling around $400 billion. By 2005, hedge fund assets had more than doubled, with estimates placing the size of the industry at more than 8,000 active hedge funds.

Are regulators a good thing or a bad thing for hedge funds?

Marketing of hedge funds to the general public has been severely restricted in most countries, and the authorities have tended to leave the funds alone, to make or lose money at will. But a number of factors are forcing regulators to take a greater interest in hedge funds, including the sheer size of the industry, the pressure to allow retail sales, and the growing volume of institutional investment into hedge funds.

The SEC attempted to tighten registration rules for hedge funds in 2005 by changing the definition of a "client" under the Investment Act of 1940 so that hedge funds managing more than $30 million in assets with more than 15 clients would be obliged to register as investment advisers. A senior SEC official revealed that hedge funds, particularly those considered by the regulator to be high risk, could expect regular inspections from compliance officers. Hedge funds whose businesses are deemed high risk would face inspections at least once every three years, while low risk hedge funds which registered with the SEC might face inspections at random.

Between 700 and 800 hedge funds were expected to have registered with the SEC, including more than 100 hedge funds based outside United States, by the time that the new rules came into force in early 2006.

After a series of legal see-saws, however, Christopher Cox, chairman of the United States Securities and Exchange Commission, announced in August, 2006, that the SEC would not seek to appeal a court decision which overturned the regulator's registration rule.

In June 2006, a three-judge panel of the US Court of Appeals for the District of Columbia Circuit unanimously struck down the SEC's hedge fund adviser registration rules under the Investment Advisers Act, in the case Phillip Goldstein, et al. v. Securities and Exchange Commission.

Based on advice from the SEC's Solicitor and General Counsel, Cox said in a statement that it would be "futile" for the Commission to appeal against the decision since the ruling was based on multiple grounds and was unanimous.

Instead, Cox explained that the SEC had changed its tack to concentrate on "moving aggressively" on an agenda of rulemaking and staff guidance to address the legal consequences following from the invalidation of the rule. "Among the significant new proposals will be a new anti-fraud rule under the Investment Advisers Act that would have the effect of 'looking through' a hedge fund to its investors," Cox stated.

"This would reverse the side-effect of the Goldstein decision that the anti-fraud provisions of the Act apply only to 'clients' as the court interpreted that term, and not to investors in the hedge fund. At my direction, Commission staff are also considering whether we should increase the minimum asset and income requirements for individuals who invest in hedge funds."

Cox continued that staff guidance can be expected to address the grandfathering, transition and other miscellaneous relief necessitated by the vacating of the rule. "This will help to eliminate disincentives for voluntary registration, and enable hedge fund advisers who are already registered under the rule to remain registered," he explained. He also stressed that hedge funds remain subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws.

"The SEC will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws. Hedge funds are not, should not be, and will not be unregulated," he warned.

The UK's financial regulator, the FSA, said that while the risk posed by hedge funds to the overall stability of the financial system is low, their growing holdings of illiquid assets might nevertheless present a danger that markets could be destabilised at a time of future crisis. In its Financial Risk Outlook report for 2006, the FSA noted that although there were now several large multi-billion hedge funds, none of these came close to the size of Long Term Capital Management, which imploded spectacularly in 1998 sparking fears of a collapse in the US banking system.

Nonetheless, the FSA went on to observe that hedge funds appeared to be increasing their investments in a range of asset classes which were "inherently less liquid than conventional assets, or whose liquidity is more likely to be reduced in times of market stress". This could contribute to further volatility in times of an economic shock or other events causing panic in the markets, the FSA warned.

The authority also cautioned that conflicts of interest may arise when hedge fund managers are trying to value particularly complex instruments, leading to a temptation to over-state the value of assets, especially as assets under management are one of the key criteria governing fund managers' performance fees.

In 'Old Europe', the financial authorities viewed hedge funds as on a par with nuclear waste. Jaime Caruana, Chairman of the Basel Committee on Banking Supervision, told Reuters that more transparency was needed in the hedge fund industry given that many banks now have exposure to the lightly regulated industry. "Efforts to improve the level and the quality of the information disclosed are necessary in order to allow investors and market participants to properly assess the risks they are assuming," Caruana stated. He urged banking institutions to exercise caution in their dealings with hedge funds, which have come under the spotlight of many regulating institutions because of their unaccountability, despite controlling billions of dollars in assets in the world's markets.

"As banking supervisors, we should emphasize that banking organisations measure and control their exposures to hedge funds accurately," he stated.

While Caruana acknowledged that hedge funds play a positive role by improving the efficiency of markets, he cautioned that there are two sides to the coin because hedge funds often buy risky assets from regulated entities such as banks, which must set aside reserves to cope with any potential loss.

"Hedge funds ... are active players in risk transfer markets, where risks are transferred from credit institutions to other investors. There could be a risk of hedge funds engaging in regulatory arbitrage, leading finally to the financing of high risk profile borrowers," he observed.

Edgar Meister, chairman of the Banking Supervision Committee of the European Central Bank (ECB), warned that the rapidly growing hedge fund industry had the power to destabilise European financial markets, and hinted that the potential risks posed by hedge fund trading activity warranted closer scrutiny. Presenting the ECB's annual report on banking stability, Mr Meister noted that hedge funds could "seriously affect" financial stability through their largest creditors and counterparties - in other words, banks. He went on to add that the "opacity" of hedge funds affected banks' ability to "aggregate their exposure to hedge funds," meaning that "monitoring" of the situation might be necessary where EU banks are concerned.

Mr Meister's words joined a growing chorus from many regulators that hedge funds now wielded too much power over the workings of financial markets. Jochen Sanio, head of German financial supervisor BaFin, repeatedly warned that hedge funds "pose a big threat" to financial stability, while the International Organization of Securities Commissions (IOSCO), the global securities markets regulator, busied itself drafting new rules aimed at controlling the increasingly influential $1 trillion hedge fund industry.

The Amaranth debacle in 2006 led to a renewed push by regulators for stringent control of hedge funds, but once again the industry seemed to have remained free of the controls that would probably sap its life-blood, and took significant steps towards improved self-regulation, with the development of a unified set of global 'best practice' standards.

Denying strenuous efforts by the prominent European politicians and bankers to rein in the hedge fund sector, US Securities and Exchange Commissioner Paul Atkins said in September, 2007, that no new regulations on hedge funds were needed. He said the SEC would continue its probe into whether Amaranth misled investors, but that rules to prevent a widespread systematic failure in the market had worked. "It looked like the system worked" with the broker "getting nervous about exposure and taking steps to ensure it did not grow," Atkins told reporters in Brussels.

Needless to say, the cataclysm of 2008 brought new pressures for additional regulation of the free-wheeling hedge fund sector. In December, the Commission launched a wide-ranging public consultation on policy issues arising from the activities of the hedge fund industry, in view of developing appropriate regulatory initiatives. The results of the consultation were discussed at a high-level conference in Brussels in late February 2009, and will serve as the basis for European input into the parallel reflections on hedge funds at international level by the G20.

The consultation is part of the Commission's comprehensive review of regulatory and supervisory arrangements for all financial market actors in the European Union, which is to be finalised in 2009 upon consideration of the report of the High Level Expert Group chaired by Jacques de Larosière. It also responds to the recent reports by the European Parliament, which raise a number of concerns that have come into sharper international focus as hedge funds have, like many other financial actors, been heavily affected by the current financial crisis.

Industry associations, which had tended to be insouciant about the dangers of their proteges, no longer felt able to stand out against the pressure. "The Commission is right to address areas of concern about the hedge fund industry," said AIMA’s CEO, Andrew Baker, adding: "I would say that many of these issues are not unique to hedge funds and should not be looked at in isolation. It is also important to stress that the hedge fund industry in Europe is currently regulated and that regulatory framework has shown itself to be robust in very difficult market conditions."

"The hedge fund industry in Europe and elsewhere has been hit very hard by the current crisis, but has responded in an orderly way and has not triggered any systemic risks. Hedge funds did not cause the present market turmoil and because they have an essential role in providing liquidity to the markets, are important in assisting any eventual recovery."

Baker concluded: "We look forward to working with the Commission and other bodies to formulate a regulatory framework for the future and we believe the active cooperation and leadership we are providing on behalf of the industry will prove helpful.”

By February, 2009, AIMA was being noticeably more complaisant, saying that it would support the principle of full transparency and supervisory disclosure of systemically significant positions and risk exposures by hedge fund managers to their national regulators.

The initiative, announced by AIMA on February 24, is one of a series of policy positions in the association’s new platform. Other key new strands of the platform include an aggregated short position disclosure regime to national regulators, support for new policies to reduce settlement failure (including in the area of naked short selling), and a global manager-authorisation and supervision template based on the model of the United Kingdom's Financial Services Authority (FSA) and a call for unified global standards for the industry.

The association is representing the global hedge fund industry in on-going international discussions about the future regulatory framework for the industry, notably with the organisations tasked by the G-20 to address the issue, such as IOSCO and the Financial Stability Forum.

The policies in AIMA’s new platform include:

• Regular reporting and increased transparency of systemically significant positions and risk exposures by managers of large hedge funds to their national regulators (the regulator of the jurisdiction in which the manager is authorised and registered to operate).
• An aggregated short position disclosure regime to national regulators.
• Support for new policies to reduce settlement failure (including in the area of naked short selling).
• Support for a global manager-authorisation and supervision template based on the UK’s FSA model.
• A call for unified global standards for the industry based on the convergence of existing industry standards work, such as that authored by AIMA, the Hedge Funds Standards Board, IOSCO, the President's Working Group and the Managed Funds Association.

Said Andrew Baker: “We want to dispel once and for all this misconception that the hedge fund industry is opaque and uncooperative. That’s why we are declaring our support for the principle of full transparency of systemically significant positions and risk exposures by hedge fund managers to their national regulators through a regular reporting framework. We are confident that our members recognise that it is in everyone’s best interests if we cooperate fully in the important on-going international efforts to examine and improve the supervisory framework of the future.”

The advantages of hedge funds

As previously mentioned, hedge funds are a lot more nimble than their mutual fund counterparts. This is because they are governed under a different (and much more permissive) regulatory system than traditional funds, which means that they are permitted to use instruments and strategies beyond the reach of conventional mutual funds, in order to secure the highest possible profit for investors and best manage investment risks.

Broadly speaking, hedge fund managers (or general partners, as they are more usually known), unlike mutual fund managers, are able to change the style or strategy used by the fund without prior investor consent, and the spectrum of styles available is enormous. The following (by no means exhaustive) list outlines some of the main strategies utilised by hedge fund managers, and the way in which each hopes to affect the performance of the fund:

• Event-Driven. This strategy involves taking different positions in companies which are involved in takeovers, mergers, or acquisitions, or are in distress, in the hopes of predicting the effect that the event will have on their share prices. The Greenwich-Van Global Event Driven, Market Neutral Arbitrage and Equity Market Neutral Indices returned 1.06% (8.13% YTD), 0.80% (7.68% YTD) and 0.03% (4.47%YTD) in August, 2006, respectively.
  
• Global International. Investing either in established markets, or in more risky emerging economies. For August, 2006, the Greenwich-Van Global Income, Emerging Markets and Multi-strategy indices returned 1.14% (5.86% YTD), 0.91% (10.17% YTD) and 0.38% (6.38% YTD), respectively.
  
• Global Macro. Seeks to benefit from global macro-economic changes and developments.
   
• Sector. Investing in a specific sector, for example financial services, real estate, or technology and communications.
  
• Long/Short. Taking a long position in a stock is what most traditional investors and mutual fund managers do - they predict that the value of the stock will rise. However, in a hedge fund, alternative financial instruments can be used. Shorting involves finding overvalued companies, and selling borrowed stock in them in the hopes of buying it back later at a lower price. Greenwich Van reported that the Long/Short Equity Group returned 1.43% in August, 2006 (6.79% YTD) as managers were helped by gains in most traditional equity benchmarks. Greenwich-Van’s Global Value, Aggressive Growth, Opportunistic and Short Selling Indices returned 1.72% (7.24 YTD), 1.50% (5.56% YTD), 1.05% (7.11% YTD) and -1.65% (+2.30% YTD), respectively.
  
• Market Neutral. This involves taking both long and short positions in the same market or sector in order to offset risk - basically like betting on two sides of the same coin. The Greenwich Van Market Neutral Group yielded 0.75% in August 2006, (7.28% YTD). The arbitrage strategies continue to deliver strong returns in 2006. Improving credit spreads, a strengthening bond market, and slightly higher single stock volatility created a very good environment for convertible traders in August, the company said.
  
• Fund of Funds. Funds of funds (FOFs) don't invest directly in market instruments, but take positions in selected funds, meaning that they can use a mixture of strategies, or specialize in just one.

There are many more strategies open to hedge fund managers, of course, and they are able to chop and change as market conditions dictate.

Hedge fund managers are usually highly skilled and experienced, as the system and rates of compensation for successful managers tend to be very attractive. Although a successful mutual fund manager may well be able to afford a weekend home with a pool on his earnings, a successful hedge fund manager is more likely to have a weekend home with an island. Or so the saying goes.

General partners are compensated in a very different way to mutual fund managers, as the majority of their fee is based on how well the fund performs. Generally, their fee is something like 1-2% of the total assets of the fund, plus a performance or incentive based fee. Some funds also stipulate a 'watermark' or 'hurdle' which the fund must outperform in order for the manager to profit. Hedge fund managers are also usually more heavily invested in the funds they run themselves, and so have more of a vested interest in ensuring that the fund performs exceptionally. Mutual fund managers usually base their fees on the volume of assets managed, regardless of performance.

Disadvantages of hedge funds

Which brings us neatly onto the possible disadvantages of hedge fund investment. Although the way in which hedge fund managers are compensated can, and in the majority of cases does, encourage excellence and shrewdness, it can also sometimes encourage greater risk-taking in order to ensure that the fund is productive.

The relative lack of regulation in the hedge fund sector of most countries is something of a double-edged sword, and the ability to invest in 'volatile' sectors or instruments can sometimes present a risk. The occasional demise of very large hedge funds has enhanced the public perception of this risk. At the end of 2008, the Bernard Madoff investment scandal highlighted more than ever the need for independence in the administration and valuation of hedge funds.

“The Madoff scandal highlights just how important it is to have independence of process in relation to administration of the fund and the valuation process," said Antonio Borges, chairman of the Hedge Fund Standards Board. He added: "It also highlights the need for robust governance practices and oversight via independent boards, which will challenge management procedures and behaviour."

Bernard L. Madoff, who ran Bernard L. Madoff Investment Securities LLC – considered to be one of the most successful hedge funds in the world – was arrested after being jointly charged by the Securities and Exchange Commission and the Justice Department for allegedly orchestrating a giant Ponzi scheme. According to the charges, Madoff admitted to senior employees that his fund was "one big lie" which had been paying 'returns' to certain investors out of the principle capital invested by newcomers to the fund.

It is thought that losses from the fraud could reach USD50bn, and it has since emerged that many high profile banks still reeling from sub-prime losses may have lost large stakes in Madoff's fund. It has also come to light that regulatory checks by the SEC in 2006 and 2007 failed to uncover anything suspicious, while questions have also been asked as to why Madoff did not use a custodian to hold the fund's assets, and why he chose to employ a little-known New York-based auditor while funds of a comparable size would employ a much larger audit firm.

Universal hedge fund standards are intended to reduce the risk of such events. "The hedge fund standards are designed to address exactly these issues to help prevent such events from happening, and to provide investors with the necessary transparency. This is why an increasing number of managers are signing up to the HFSB standards," said the Hedge Fund Working Group (HFWG), a group of leading hedge funds based mainly in London, whose report on best practice standards was published late last year.

However, many experts feel that the risky nature of hedge fund investment has been overstated. Although managers are generally somewhat secretive about investment strategies, and reporting to investors does not take place as frequently as with conventional investment vehicles, there is no fundamental and necessary reason why hedge funds should present more of a danger. On the contrary, academic research conducted over the past few years has shown that hedge funds have had higher historical returns than traditional stock and bond investments of similar risk.

In reality, less than 5% of the world's hedge funds utilise 'risky' investment strategies such as global macro or emerging markets. Most hedge funds only use derivatives for offsetting market risk, and many do not use leverage at all. (Leverage is the extent to which an investor, business, or fund is using borrowed money to finance transactions).

Be that as it may, securities regulators have always been keen that inexperienced domestic investors are not exposed to any more risk than is strictly necessary, and one area in which they do impose strict regulation for hedge funds is in the barriers they place in the way of investors themselves.

As well as passing muster in terms of investment knowledge and experience, a potential investor must be prepared to stump up a sizeable minimum investment, and must be able to demonstrate a substantial net worth. This is in part to deter the unwary, and in part because as hedge funds are limited by the authorities in the number of investors that they can accept, a large sum is needed from each investor in order to make the venture worthwhile.

The criteria for accredited, or qualified investors have been defined as follows in America, and it is safe to assume that similarly stringent definitions exist in other countries, although consultation with an independent financial advisor will clarify exactly what the situation is in your country of residence:

• Must have an individual net worth, or joint net worth with spouse exceeding $1 million, or;
  
• Must have had an individual income of $200,000 (or joint income of $300,000) in the two years preceding, and have a reasonable expectation of a similar level of income in the current year, or;
  
• Must be an institution, employee benefit plan, partnership, or foundation which meets the accredited investor criteria.

At this point you may be wondering why, if all but the super-rich are excluded from investing in hedge funds, we have bothered to write a primer on hedge fund investing. Well, as the 'mass affluent' group continues to grow, so does the popularity of hedge funds, a trend which has meant that service providers are beginning to see the possibilities inherent in the sector, and are looking at ways in which to offer the increased profitability found in hedge funds to the individual investor. In the next section, we will be looking at the investment opportunities open to those unfortunately excluded from the Forbes list, but not quite in the poorhouse!

The days of online deep discount hedge fund brokers and hedge fund supermarkets are still some way off. Despite, or perhaps because of, growing investor curiosity, regulators are still cautious, and will allow hedge fund providers and managers opportunities to attract more mainstream investors only as they prove their trustworthiness.

There are however a growing number of hedge fund portals and one-stop sites for investors, advisors, and the industry alike, and they tend to offer a variety of services, including the provision of news, performance data, topical articles, and sometimes databases of contact information for service providers. As a result of still stringent regulation in the majority of countries, in order to access sensitive information (such as contact details or performance data) it is usually necessary to register.

For the moment at least, there are basically three ways to access hedge fund investment opportunities:

• Invest directly. This is only really an option for accredited investors (using the definition described above) and institutional investors due to fairly prohibitive investment criteria, although a number of countries are beginning to introduce rules for retail level hedge fund investment.
  
• Invest through an investment management company, wealth manager, or independent financial advisor. Probably a more suitable option for the mass affluent investor, as an outside financial consultant is more likely to be 'in the loop'. (Because of the restrictions on advertising, a great deal of hedge fund information is circulated by word of mouth, or on designated news sites, so contacts are important. Investing in this way also offers an added advantage (well not really an advantage, more of a necessity actually); an advisor will be able to take you through the appropriate options for your country of residence, personal circumstances, and net worth.
  
• Invest through a third party firm. As interest in hedge funds grows, a number of financial service providers are offering opportunities to invest in what are essentially funds of hedge funds, thus spreading both the perceived risk and the cost of minimum investment.

The United Kingdom's financial regulator, the Financial Services Authority (FSA), is one of those that has been toying with retail distribution for hedge funds. It announced in February, 2008, that a Consultation Paper confirming the policy of introducing retail-oriented Funds of Alternative Investment Funds (FAIFs) into the FSA’s regulatory regime had been published.

Dan Waters, FSA Director Retail Policy and Themes and Asset Management Sector Leader, commented that:

"Permitting consumers access to a wider range of innovative investment strategies through authorised onshore vehicles will allow more choice and a better opportunity for risk diversification, while maintaining consumer protection through our proportionate rules on the operation of the product. We aim to make the final adjustments to the new regime before the end of the year, including the additional areas on which we are consulting today."

He continued: "As we have previously stated, there are a number of difficult tax issues involved in the operation of onshore FAIFs regime. Following constructive discussions with the Treasury on tax issues we welcome the publication today of their tax framework, setting out a new elective regime which aims to allow FAIFs to operate competitively within the UK retail market.”

To avoid any regulatory regime being used to gain unintended tax advantages the FSA also proposes to include a ‘genuine diversity of ownership’ condition in its rules. This condition is similar to those proposed in the Property Authorised Investment Funds discussion paper issued by the Treasury in December 2007.

Are hedge funds still the best play in town?

Although there are doubts about the construction of the metrics quoted on hedge funds, for instance because of what is called 'survivorship bias', which tends to measure only surviving hedge funds and ignores those that closed, and there are concerns that 2005 saw the end of the hedge funds' glory days, the returns obtained by hedge funds have been superior to most market instruments over a long period of time.

Hedge funds do particularly well during market downturns. For instance, while the benchmark S&P 500 index lost 14%, 17.8% and 21.1% in 2000, 2001 and 2002, the Van Global Hedge Fund Index, which measures performance across approximately 5,800 funds, gained 8.4%, 6.3% and 0.1% over the same periods.

There is risk, of course. However, many experts feel that the risky nature of hedge fund investment has been overstated. Although managers are generally somewhat secretive about investment strategies, and reporting to investors does not take place as frequently as with conventional investment vehicles, there is no fundamental and necessary reason why hedge funds should present more of a danger. On the contrary, academic research conducted over the past few years has shown that hedge funds have had higher historical returns than traditional stock and bond investments of similar risk.

Funds of hedge funds, as the name suggests, offer diversification across a range of hedge funds at lower minimum investments. They are able to do this because they pool the resources of multiple investors - it has been estimated that to gain proper diversification, an individual investor would need to invest in at least 5-6 hedge funds, a feat which all but the very richest individual would find it difficult to achieve. Funds of funds can do just this because of their greater purchasing power. Typically, funds of funds will include a variety of asset classes such as equities, bonds, cash, alternative strategies, and real estate, but obviously the make-up varies considerably from product to product, and increasingly there are funds of hedge funds (FoHF).

Another, not inconsiderable advantage to investing in hedge funds in this way is that investors are able to take advantage of the expertise and resources of a number of industry professionals, as FoHF investment by necessity takes a multi-manager approach. FoHF investing may also provide access to hedge funds which would otherwise be closed to new money due to regulatory and capital restrictions.

Critics of this type of investing point to the likelihood of a higher fee structure in order to absorb both the management costs of the underlying hedge funds and of the FoHF itself, as a significant disadvantage. However, the costs involved although higher than with ordinary mutual fund investment, are unlikely to be doubled, as many fund of hedge funds providers have agreements with the hedge funds to reduce the amount of fees paid, a saving which is then passed on to the investor.

Asset management fees remained stable in 2008 but are likely to be under pressure in 2009, according to Mercer’s 2008 Asset Manager Fee Survey. This biennial report, analysing fee data on 19,000 asset management products from 3,400 investment management firms, covers asset managers in a range of geographies and across numerous products including pooled and separately managed accounts.

The survey shows alternative investment strategies to have the highest fees for each dollar of investor capital allocated.

According to Divyesh Hindocha, worldwide partner in Mercer’s investment consulting business: “One needs to take care before passing judgement on this evidence, as return and risk considerations should take priority over fees. It is fair to conclude, however, that fund of fund approaches extract a heavy premium from the alpha generation process and we would expect this to be under challenge in the new financial environment.”

The most expensive mainstream category was global emerging markets equity with median fees in the sector averaging around 0.9%. Median fees for Eastern European equity and Chinese equity, which were included for the first time in the 2008 report, were similarly high. Small cap equity also continued to be an expensive strategy with median fees around 0.8%. Active fixed income had the lowest fees amongst mainstream active strategies, with median fees continuing to average 0.2% to 0.35%.

Mr Hindocha commented: “Historically, fees are higher in those strategies where asset managers have the most potential to outperform. However, anecdotal evidence suggests that increasingly asset managers will have to negotiate their fee structures with ever more cost-conscious clients.

“Alpha is now competing with cheap and plentiful beta and capacity is no longer an issue for most strategies,” he continued. “There is the recognition that institutional investors are no longer willing to pay upfront, such large proportions of the potential alpha, especially for the more complex strategies.”

For segregated large cap/all cap equity products, Canadian equity proved the cheapest, with median fees varying from 0.25% to 0.35%. Australia, New Zealand and US equity averaged around 0.4% to 0.5 %. The UK has nudged through the top of the band with median fees in UK equity all cap products approaching 0.6%. Asia, Europe, Japan and global equity continue to be the most expensive with median fees averaging 0.5% to 0.7%.

The results were the same across small cap equity products, where Canada averaged around 0.6% relative to between 0.7% and 1% in other regions. The US small cap micro segregated fee scale remained one of the most expensive in the survey. The potential for higher return has allowed successful small cap managers to command higher fees than their broad cap counterparts. When looking at the fee premium for small caps, Canadian, global and US small caps commanded the greatest premium of between 0.25% and 0.3%. In Europe, Japan and UK equity, the premium ranged from between 0.1% and 0.2 %.

A comparison of segregated scales for fixed income showed that Australia, Canada and New Zealand were the least expensive with fees averaging 0.2%. This compares to an average of 0.3% to 0.4 % for other regions including Asian bonds. As with equities, emerging markets proved to be the most expensive, with median fees in emerging markets debt averaging around 0.6%.

As expected, the report showed that the median fees for passive, or index-based, equity strategies are 0.5% to 0.8% less than those for active strategies. Index-based fixed income strategies continue to cost 0.1% to 0.3% less than active fixed income strategies.

Due diligence

Although due diligence is a must prior to each and every investment decision, for hedge funds it is doubly so, for all the reasons previously mentioned. If you choose to invest in a fund of funds, a lot, although not all, of the work will have been done for you, but there are still some basic issues to be addressed before you part with your hard-earned (or inherited!) cash. The following is not a comprehensive list, however, so here again, professional advice is necessary.

The Fund (Or Funds…)

• Volatility - look at the fund's volatility over monthly (or weekly) periods if these figures are available. Also look at whether the annual return was generated evenly throughout the year, or whether it is the result of one or two large gains in specific periods.
  
• Breadth - if possible, check whether the general partner turned an even result on all issues, or whether one lucky trade accounted for good results.
  
• Repetition - is the investment process repeatable, or were good returns the result of dumb luck?
  
• Strategy-specific risk - important if you are investing directly in just one hedge fund, but slightly less so if you choose to invest in a fund of hedge funds due to the greater diversification offered. Still, you should make sure you understand the particular risks inherent in each hedge fund manager's strategy.
  
• Leverage - look at to what extent the fund uses leverage to make transactions, the fund's rationale for this device, and whether leverage has ever been revoked for any reason. Obviously, the extent to which a hedge fund uses borrowed money, and the rationale behind it, will affect the riskiness of the investment, so this is an important one.

The Key Personnel

• Background - look into the general background of the hedge fund, including the division of responsibility, its formation and structure, fund terms and relationships, and possible conflicts of interest.
  
• Manager profile - look into the background, qualifications, employment history and track record of the manager or managers.
  
• Reporting - Ascertain who the custodian of the fund's assets is, and also who the prime broker is. (And beware of any fund or hedge fund which asks you to send funds directly to it - they should always go to the prime broker or custodial bank.)
  
• Administration. Find out whether the hedge fund manager uses a third party administrator to calculate monthly returns, and ask for background on the fund, their calculation methods, where their data comes from, and what procedures they have in place for ensuring that the terms of the fund are being upheld. However, concentration on the terms of the fund is more crucial with mutual fund investing than hedge fund investing given the fact that hedge fund managers can change strategies at a moment's notice to fit market conditions
  
• Other investors. Although to a certain extent, you will already be aware of the general profile of other hedge fund investors (i.e. middling to filthy rich!), ask for any information that is available on the breakdown of institutional vs. individual investors, average investment amounts, etc. It may give you a clearer idea of whether the particular fund, or fund of funds, is suitable for you.

Hedge fund investment, although it appears to be slowly becoming more accessible, is never going to be the poor man's choice, and regulatory nervousness on the part of many authorities will mean that there is unlikely to be a headlong rush for the bandwagon. However, this is, in many ways, a good thing, as long experience (south sea bubbles, Dutch tulips, technology stocks, etc), has shown that a sudden rush of interest from the general public can often be too much of a good thing. Also, the vast majority of hedge funds, by their very nature, would lose a great deal of their nimbleness if they became over-subscribed.

However, the increasingly diverse opportunities within the sector, and the ever growing body of knowledge surrounding the subject mean that for a relatively wealthy and experienced investor in the right circumstances, hedge fund investment, or more realistically, investment in a fund of hedge funds, could be a financially exciting alternative.

If you do decide that this is the way forward for you, it is always strongly advisable to consult with a qualified financial professional before proceeding. Not only will they be able to help you choose the fund that is right for you, but they may well have access to information regarding performance and cost which is simply unavailable to lone individual investors.

IMPORTANT WARNING: The contents of this report have been compiled in good faith by Investorsoffshore.com to provide assistance to investors, but do not constitute investment advice or recommendations. Investors should not rely upon the information given in order to choose types or routes of investment but should make their own independent enquiries before making choices. Investorsoffshore.com has taken reasonable care in researching and presenting the information herein but makes no representations as to its accuracy and accepts no liability for actions taken or not taken as a result.