Hedge funds have a lot to prove in 2012

Date: Wednesday, January 25, 2012
Author: David Kaufman, Financial Post

In what Reuters labelled the “great hedge-fund humbling of 2011,” hedge funds across North America collectively suffered one of their worst years on record, in many cases underperforming even mutual funds, which themselves have come under increased scrutiny in recent years for their inability to provide returns to investors in excess of the markets against which they are benchmarked. Excuses and explanations abound, most of which are tied to volatility in the global markets coupled with a variety of natural disasters and significant central bank interventions. In some cases, managers have even used the excuse of last resort: admitting they made mistakes.

After having conducted annual review calls with numerous hedge-fund managers operating vastly different investment strategies — many of which underperformed simultaneously in 2011 — I am still without a comprehensive, articulable explanation.

I have, however, been able to glean some general thoughts from this process that I hope will serve hedge-fund investors well going forward.

Smart managers don’t become stupid overnight It is generally accepted that many of the world’s best and brightest investing minds are hedge-fund managers. This is especially true in Canada, where the experience of many top managers included the successful management of very significant amounts of money (and risk) for Canadian banks before launching their own funds. If these men and women had such a hard time making money in 2011, I’m willing to concede that the year’s global events conspired against them rather than throw in the towel on their clear and well-documented expertise.
Bigger isn’t better Many pension funds and other institutional investors have firm rules regarding the minimum assets under management that a hedge fund must have to be considered for inclusion in their portfolio. While this may be logical for investors allocating tens of millions of dollars at a time, this sort of thinking will work against most investors. Many younger and smaller funds execute opportunistic strategies that by definition have limited capacity and shelf life. Once these strategies are identified by the investing community at large as providing outsized returns, it’s often too late to jump on the bandwagon and reap the rewards.

Don’t confuse dynamic tactical investing with style drift  During the due diligence of a hedge fund, it is critical to identify what investment style a manager adopts in order to judge suitability for investment and identify “style drift” in the future. That said, it is equally important to give managers enough leeway to be able to capitalize on opportunities that they identify along the way without being overly constrained by investor expectations. If a long-short equity manager suddenly starts trading foreign currency futures, this might be a cause of concern. But if a “multi-strategy” manager trades in U.S. equities and Canadian sovereign debt in one period and emerging market equities and corporate bonds in another, this might be a sign that they are seeking out the best risk adjusted returns among the various asset classes in which they have demonstrated true expertise. This is a good thing.

Excess returns matter Most hedge funds charge fees based on the “2 & 20” model, meaning 2% annual management fees plus 20% of profits over a predefined hurdle. While these high fees should not logically act as a disincentive to invest in their own right, they can only be rationalized when net-of-fee returns are, on average, higher than those that could have been achieved at a much lower cost. While a quarter (or even an entire year) might be too short a period to assess the added value of any individual manager, the absence of excess returns in the presence of high fees  in any period means that investors have every right to put their managers’ feet to the fire.

Having made the decision to invest with a number of hedge-fund managers based on long-term investing and risk-management expertise, our firm did not initiate any redemptions based on disappointing 2011 results. We will continue to monitor not only the returns of the managers we favour, but their strategies and execution as well. Although a “new normal” has emerged in the world of investing, we believe that the top hedge-fund managers will adapt, finding ways to deliver excess returns to their investors, thereby earning their significant fees.

David Kaufman is the president of Westcourt Capital Corp., an Exempt Market Dealer specializing in conservative, alternative income-generating investments. drk@westcourtcapital.com