Hedge funds shun risk-taking practice, as do their investors

Date: Monday, September 10, 2012
Author: David Walker, Investment Europe

The stereotype of a hedge fund manager is of a gambler on markets, a high risk taker. At the moment, however, the reality is flying in the face of that archetype.

Then you read industry biographies of years past, the picture is of managers betting big, all on 'Black 27' -or whatever number they chose at the time.

But there is ample evidence this 'bet-and-bet-big' picture is very, very far from the truth.

Net long exposure for hedge funds is in the area of 43%, a level mentioned by Goldman Sachs analysis late last month. In other words, managers are not taking big directional bets on share markets.

If managers are cautious (even nervous?) about which way markets will head, then it is also evident that they are not alone - indeed, their clients seem to feel the same way.

Anthony Lawler, portfolio manager at allocator GAM, said: "Hedge fund managers generally maintained low risk levels in August with upside risks remaining from policy interventions and central bank actions; these were balanced against the downside risks of a global growth slowdown and stubbornly high unemployment levels."

For some clients, who consider that ‘flat is the new up', even if hedge funds weaken a little this half the final returns come Christmas might still look fine.

(For those clients who want more, hedge funds are at risk of disappointing. While the MSCI World made 5.18% gains by August, directional equities hedge funds made just 2.62%.)

For many investors, what happens to directional punters may not matters, as many investors are looking for other investment strategies entirely.

Equities strategies, which mainly punt on single securities' directions, had $1.3bn drained from them last quarter. They lost nearly 20 times more than that on their investments.

At the same time, funds that try to predict which relative directions two related equities will make, took in $9.9bn. It was the only one of four major strategies to win new cash last quarter, according to Hedge Fund Research. ‘Relative-value' funds lost a modest $479m on their investments.

‘Relative-value' strategies are poised to overtake ‘equity hedge' funds as the industry's most popular strategy, by assets. At the moment they are almost equal (26.43% of industry assets versus 27.13%).

Those equities strategies that reduce their directional bets by balancing assets in long positions with assets in short positions (so-called ‘market-neutral' strategies), have been seeking new ways to reduce directional risk.

Ian Heslop, manager of Old Mutual Asset Managers' Global Equity Absolute Return hedge fund, said market-neutral hedge fund managers have reconsidered over past years the whole concept of ‘market neutrality', and whether balancing long assets with shorts actually "squeezes out market risks from a portfolio.

"We as an industry used to think about that as being a portfolio construction conundrum, and it is true you must have effective portfolio construction processes being beta-market-neutral. But it is not just that that is important. Macro impacts or correlation can have huge impacts on your outcome.

"You may think you have a market-neutral portfolio, but you invest heavily in value. You may not have market risk at the beta level - so you may think you are market-neutral - but fundamentally value is correlated to the market because of the risk appetite.

"So even though you have no net exposure to the market, your returns are correlated to that market."

Heslop's concerns on market exposure risk are borne out by global equities analysis from software firm Axioma, which showed various factors have produced widely divergent returns since mid-2011.

The ‘value' factor has actually been quite neutral, generating less than 3% gains over the period, but exposure (intended or not) to the ‘volatility' factor would have lost investors nearly 15%.

Melissa Brown, senior director, applied research at analytical software provider Axioma, said: "With the factor ‘volatility' you can just get clobbered. You have to think about risk and return being two sides of the same coin and if you are a good return forecaster but not thinking about risk at the same time, you may end up getting hurt, although it has nothing to do with your skill." (See graph below, from Axioma)

Brown said part of a manager's skill should be knowing what risk they are better equipped at taking, and focusing on that.

Heslop acknowledged, back in May as events in Athens/Brussels swayed whole asset classes, that "not making the wrong decision is as important as trying to make the right one.

"In the long term, you can end up with mis-priced stocks and you can tap into that, but you must also recognise that in the short term, there can be extreme jumps that can hit you. When you have an unstable macro environment, like in 2010 when you had ‘risk-on' at 0900 and risk-off by noon, it was very difficult, and managers could be either lucky, or not."

Factors and their returns