Hedge Funds explained

Why all the hype?

Should you invest in Hedge Funds?

By Evan Cooperman

March 2, 2005

Hedge funds have been garnering increasing amounts of attention, and as with Portus, not always of the positive variety.  So what’s the deal with Hedge Funds anyway?  Clearly they are not a passing fad and we feel that all our clients should be paying close attention to this asset class.   

Over the coming months I will attempt to explain the universe of Alternative Investment Strategies (AIS).  This inaugural letter will provide a brief introduction to Hedge Funds and subsequent letters will focus on explaining specific hedge strategies.  My hope is to provide you with insight into this magical world, where investors are taking less investment risk, AND being rewarded with higher returns.  If this sounds too good to be true then I invite you to consider the following scenario.

Flashback

It is November 1999.  Your kids are listening to Livin’ La Vida Loca by Ricky Martin and talking about Star Wars Episode 1 – The Phantom Menace.  The US Senate has acquitted President Clinton in his impeachment trial and people are still coming to terms with the Columbine Massacre.   The Nasdaq has run up 52.35% amid talk of ‘bricks and clicks’ and ‘this time it’s different’ while the S&P 500 delivered a rather tame 14.31% return.  You are looking forward to your December holiday in warmer climes, blissfully unaware that the next five years will witness the burst of the stock market bubble and the bear market to follow (apparently this time it wasn’t different with Nasdaq declining 74% and S&P 500 declining 44%!!).  America will experience a contentious election between Bush and Gore, face the horror of the 9/11 terrorist attacks and go to war in Afghanistan and Iraq.   The US economy and stock markets will go into recession, followed by recoveries and finally by uncertain, choppy markets.  Not a great time to be investing right?  Well let’s have a look.

Suppose that, back in November 1999, you were choosing between investing in a balanced portfolio that did not include hedge funds versus one that did.  The results of the two decisions are detailed in the chart below.

 Annualized results from November 1999 to December 2004

November 1999 to December 2004 is a good representative period to look at because it encapsulates the end of the market bubble, followed by substantial market declines, a market recovery, followed by choppy sideways markets.  If you had decided to invest in the traditional balanced portfolio you would have earned 5.30% per year, not a terrible result considering events during that period.  Now, what would have happened if, instead of investing in the balanced portfolio, you had invested in the portfolio that includes alternatives?  In this case you would have had a much higher return of 8.09% WITH lower volatility, or in English, higher returns for less risk.    

Explosive Growth

Higher returns, coupled with the calming impact that hedge funds can have on a portfolio, may be the reason that the hedge fund industry is experiencing exponential growth.  According to TASS Research, net asset inflows into hedge funds totalled $72.2 billion in 2003, up 342% from the $16.3 billion in 2002.  To put this growth in perspective, it is estimated that in 1980 the industry had $193 million under management, rising to $7.2 billion by 1990 and approaching $1 trillion today!

To date, drivers of this growth have been UNWH (Ultra-High Net Worth Investors with $25 million or more in investable assets) and institutional investors.  According to Ricardo Cortez at Torrey & Associates, these early adopters have now invested anywhere from 5% to 50% of their entire portfolios in Alternative Investment Strategies.  For the most prevalent example of this we can consider David Swensen, the manager of Yale’s $11 billion endowment fund.  Over the last 20 years, during his tenure, the fund has had an annual return of 15.1%.  Why has Swensen allocated 25% of the portfolio to Hedge Funds and 36% to other Alternative Strategies?  Why the explosive growth?  The answer is simple – a desire for Absolute Returns.

Absolute Returns

Hedge funds strive for absolute returns – or in other words, they strive to deliver positive returns with low correlations to traditional asset classes like stocks and bonds. 

Hedge Funds Defined

OK, so now we know that, in general, a hedge fund seeks to deliver returns that are indifferent (uncorrelated) to the market.  But, what is a hedge fund?  Alexander Ineichen, in his encyclopaedic book ‘Absolute Returns’, defines a hedge fund as “an investment program whereby managers or partners seek absolute returns by exploiting investment opportunities while protecting principal from potential financial loss”.  Keywords to note are ‘positive returns’ and ‘protection from loss’.

While this is certainly a concise definition, we always like to tell our clients that hedge fund can also mean ‘unregulated’ (although this is starting to change). The fact that hedge funds are unregulated marks a significant difference to other types of investment vehicles and leads to both positive and negative factors.  The unregulated nature allows hedge funds to be nimble and opportunistic in their investment strategies while at the same time it increases potential for malfeasance at the hands of managers.  We will examine these factors in upcoming e-letters. 

It is interesting to note that, from a structural perspective, Warren Buffet’s original investment partnership could have been considered a hedge fund.  The partnership was founded in 1956 with 7 limited partners.  Buffett, then 25 years old, charged a fee equal to 25 percent of the profits, which he was only allowed to collect after his investors earned a minimum return of 6% per year.    Buffet’s fee arrangement, along with his stated goal of capital preservation, look very much like the absolute return objectives of many hedge funds today.  One final note on Buffett.  Although he may be considered the quintessential long only, value investor, Buffett has actively engaged in various forms of arbitrage (a.k.a. hedge strategies) – primarily risk arbitrage and fixed income arbitrage (more on these in subsequent e-letters).  

General Characteristics

Typical hedge fund structures include limited partnerships, limited liability companies, unit trusts or listed entities.  Many hedge funds are domiciled in offshore jurisdictions and, since there are adverse tax implications for Canadian investors who invest in offshore funds, some funds will offer structured versions for domestic investors.  Investors in products that are wrapped in tax structures will typically benefit from a deferral of taxes with capital gains treatment upon exit.  We will also examine tax efficient investing in upcoming e-letters.

Hedge funds can be classified as either single manager or multi-manager, single strategy or multi-strategy and finally, as Funds of Funds.  Funds of Funds combine many managers and strategies in order to diversify risk. 

Average hedge fund management fees range from 1% to 2% per year, with a 10% to 20% share of profits (known as a ‘carried interest’ or ‘performance fees’).  Usually, performance fees are subject to what is known as a ‘high-water mark’.  The high-water mark ensures that a manager only takes performance fees on the value added to the investor.  This means that if the fund has negative returns, the manager does not get performance fees until the fund goes back above its previous highest value.  (ie. If the fund starts at 100 and declines to 75, the manager does not get performance fees until the fund goes back above 100) This, when combined with the fact that a large portion of the hedge fund managers’ personal wealth is usually invested in their own funds, increases the managers’ incentive to achieve positive results.     

Hedge funds typically sell or redeem units monthly, but certain strategies may require lock-up periods during which investors cannot redeem their investment. Lock-up periods for hedge funds range from 3 months to 1 year, but can be longer. Also, some quarterly redemption policies may require a long notice period (e.g., 45 days). Some funds charge early redemption penalties.

Varying amounts of leverage are used in most hedge fund strategies.  The amount of leverage employed is determined by the underlying strategy and its associated risks. 

Conclusion 

Including Alternative Investment Strategies in your portfolio helps to further diversify your interests while reducing the potential for negative compounding.  This was well demonstrated in 2002, the worst year of the 1999 to 2004 period.  In that year, the traditional portfolio was down 7.24% while the portfolio that included hedge funds was down 1.93%. 

As long as mis-pricings exist in the market, there will be opportunities for hedge funds to make money.  The benefits of having hedge fund investments can be exceptional, but not without risk.  Due to the unregulated nature of hedge funds, proper due diligence and careful selection of hedge fund managers takes on much greater importance.   

We firmly believe that with a properly designed, well implemented asset allocation, your portfolio should enjoy the benefits of participating in the upside of the markets while mitigating losses on the downside.   

Utah, homework and the longs and shorts of it

In March I will be heading to our annual Prime Quadrant business planning retreat in Park City, Utah.  This year we will be focusing on our marketing strategy and how to get the word out that we are redefining the wealth management model for High Net Worth families in Canada.   I am really excited about the opportunities that 2005 represent for us to help our clients take risks for which they are amply rewarded and to invest the way High Net Worth investors do in the US. Upon my return I will be diligently working on my homework from my wedding planner (I am getting married in June!) and also next month’s letter in which we will start delving into individual hedge fund strategies by having a look at Long/Short Equity.

Note:

This e-letter is the first of my monthly newsletters.  I would like to ask that you do me the favour of sending me some feedback to let me how useful the content is. (Be honest – I can take it!)  In addition if you have requests or suggestions on subject matter for future e-letters I would greatly appreciate your letting me know.  If you do not wish to receive these emails in the future, please let me know by sending an email to ecooperman@primequad.com.  If this email has been forwarded to you and you would like to subscribe, please contact me at ecooperman@primequad.com