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Rumours of hedge funds' death are greatly exaggerated


Date: Monday, June 15, 2009
Author: Globe and Mail

The hedge fund association for Canada, called the Alternative Investment Management Association, held a lunch on Tuesday that featured a debate between Toreigh Stuart, chief executive office of Man Investments Canada Corp., and Tom Bradley, president of Steadyhand Investment Funds and Globe Investor columnist on Saturdays.

The resolution: Hedge Funds are Dead, with Mr. Bradley taking the 'for' position and Mr. Stuart taking the 'opposed.'

Here are columns summarizing their positions. We'll let you decide the victor.

You can read Tom Bradley's column: Hedge fund companies are fundamentally flawed and on their deathbed.

Here is Toreigh Stuart's view.

Rumours of the death of hedge funds have been greatly exaggerated.

Hedge fund strategies remain very much alive and still are the wave of the future for money management. The problem with them in Canada during the past year was that too many of them performed no better than most traditional long-only equity funds. The latter, unlike hedge funds, are mortally flawed investment vehicles that deserve to be buried in a coffin lined with printouts of their capital-eroding histories.

Oddly, Mr. Bradley and I agree a lot when it comes to investment philosophies. We both believe in the dangers of funds being allowed to grow too big for them to be managed nimbly, that managers should be "eating their own cooking" by investing in their own funds, and that risk reduction matters - all concepts at the heart of hedging.

A decade of working in the traditional mutual fund industry convinced me something was seriously wrong with it: Too often, it appeared, the focus was on pooling my clients' money rather than actively managing its growth. Here are some of the reasons I switched to hedge funds from traditional investing:

Traditional equity investing generally exposes investors to excessive risk of losses.

In aggregate terms, hedge funds have done a far better job than traditional equity products of protecting investors from large losses in most any market climate. Global stock markets declined by almost 50 per cent during this bear market, while the Hedge Fund Research Institute (HFRI) fund-of-funds composite index dropped 21 per cent. Although many hedge funds failed to deliver absolute returns in 2008, over all they continued to provide significant downside protection.

Traditional equity investing typically cannot deliver profits during tough economic phases.

Many hedge fund strategies are built to provide for the potential of investment returns in both rising and falling markets over a medium to long term. Looking at returns for 2000 to 2008, global stocks fell 20 per cent while the HFRI composite rose about 40 per cent. If you are at or near retirement, you cannot afford to rely on equities alone to provide retirement income. You must seek out the types of investment solutions many hedge funds offer.

Traditional equity investing usually does not allow enough tools to manage portfolios properly.

In contrast to their mutual fund counterparts, who have little defence against declining markets, hedge managers can achieve exceptional medium-to-long-term risk-adjusted returns in any market scenario because they have so many tools at their disposal - among them cash instruments, timely long/short positions, arbitrage strategies, and the blending of hedge funds into a "fund of funds" for greater stability of returns. This is why hedge funds commonly are able to yield above-average returns at reduced risk. Even Tiger Woods could not conquer a golf course littered with bunkers and water traps if, like an average mutual fund manager, he had only one club at his disposal.

Stating "hedge funds are dead" is like saying managerial skill is dead. Investors will always be interested in accessing the more robust investment strategies available through hedge funds. Volatile markets offer an outstanding environment for talented professional investors who are able to go long or short in a wide array of markets.

Propagandists representing the dominant mutual fund lobby tend to demonize hedge funds, and predictably have blamed them for the present global credit crisis. How could this be when hedge funds comprise only 1 to 2 per cent of total investment assets worldwide?

So do I feel the hedge fund industry is blemish free? Not at all, not any more than parliamentary democracy is perfect.

However, the hedge community has acknowledged the challenges and disappointments felt by many through 2008, and is taking the steps necessary to evolve accordingly. Our industry is working pro-actively to raise disclosure and governance standards, while weaker hedge funds, unable to comply with new, tougher standards, fold their tents.

Recognizing that hedge fund tools and techniques are fundamentally sound, private and institutional investors alike are using them as a diversification strategy to preserve and grow capital. Those tempted to redeem hedge fund holdings should look beyond alarmist media headlines and recognize that hedging strategies are poised to reward loyal investors with superior risk-adjusted and absolute returns into the future.


The resolution: Hedge Funds are Dead, with Mr. Bradley taking the 'for' position and Mr. Stuart taking the 'opposed.'

Here is Tom Bradley's view.

This debate was scheduled for April, but the association had difficulty finding anyone to take the affirmative side in a room full of hedge fund managers. When they finally found me, I embraced the opportunity because of my contrarian nature - if nobody else wanted to do it, there must be something there.

I also liked the fact that I start the debate with a fee advantage. (At 1.25 per cent, the fees on my Steadyhandfunds are two to three percentage points lower than Mr. Toreigh's Man Investment funds.)

There are three reasons why an investment management structure that is client unfriendly, non-transparent, underregulated and charges exorbitant fees is dead.

First, I contend that the growth of hedge funds in the early part of this decade was the result of a specific confluence of events that will not be repeated, and indeed, have turned unfavourable. Excellent performance during the tech meltdown of 2001 and 2002 ignited the boom, but a number of factors that were uniquely beneficial to hedge funds fuelled it.

From 2003 to 2007, we had a bull market in equities and bonds. Everyone was making money, which meant scrutiny was at a minimum and the more leverage the better. The "carry trade," whereby managers borrowed in Japan at a nominal cost and invested in longer-term assets, was a one-way street. These strategic mismatches just kept working.

Managers had few constraints placed on them. There was an unlimited amount of credit available and stocks could be shorted cheaply. Regulation was benign.

Perhaps the most fuel came from a pension industry in crisis. Post tech meltdown, these institutions were desperate for higher returns that had a low correlation to the stock market. Encouraged by David Swensen's success at Yale University, the appetite for hedge funds was voracious and the stomach was empty.

It is this feeding frenzy that leads me to my second argument: Hedge fund managers let themselves get overweight. They became asset gatherers. Money flowed in and firms ballooned both in numbers and size. Instead of maximizing added-value for clients, which performance fees are supposed to encourage, firms went for the assets. As a result, their agility, freedom and stealthiness have been compromised. It is an ironic twist of fate that after heaping scorn on conventional asset managers for being bulky and slow moving, it turns out that hedge funds have followed the same path.

Finally, the business model of a hedge fund company is fundamentally flawed.

First, their relationship with clients is "Heads I win, tails you lose." Not only is the fee structure aggressive, but the documentation, liquidity rules and lack of transparency are tilted heavily in the managers' favour. It is rare that a business so unfriendly to its clients can survive without change when the going gets tougher.

Second, hedge funds are heavily reliant on packagers for distribution. Specifically, fund of funds companies (FOFs) that pick managers for their clients. These distributors are necessary because clients don't know enough about hedge funds and need help diversifying away the risk of being Madoffed. The problem is that FOFs have proven to be an unreliable source of long-term capital, as the wave of redemptions last year demonstrated.

Finally, hedge funds are totally sold on performance, and that's a tough way to build a sustainable asset management business.

Already, the industry is shrinking rapidly. Assets under management dropped almost 50 per cent from peak to trough, with redemptions responsible for a majority of the decline.

Fees are also coming down. Two and 20 (management and performance fees) is becoming the exception, not the rule. To keep existing clients, firms are giving fee reductions and new clients are being offered 1 and 15, and even 1 and 10. It's easy to reduce fees, but almost impossible to raise them again.

Last but not least, the performance has not lived up to expectations. Despite favourable tail winds, overall returns since 2002 have been unremarkable - in line with conventional balanced funds. But more importantly, hedge funds let their clients down in 2007 and 2008 in an environment when they were expected to shine.

With a tougher environment ahead, increased scrutiny from regulators and clients, and a weaker performance record to sell, the hedge fund model as we know it needs to change. If it's not dead, it's certainly in intensive care.