Should I Invest in Hedge Funds?

I have a business proposition for you. Here’s how it works: You put up all of the money, and I will invest it for you. For my efforts, I will share in the investment returns with you. Depending on the time period and rate of return earned, I’ll likely get to keep about 50 -75% of the returns, but on average, I’ll get about 60% of the returns over the first 10 years. If things don’t work out well, you’ll absorb 100% of the losses, but you will still pay me an annual management fee for my efforts. You won’t be able to measure how well I’m doing as there is no reliable benchmark against which I can be measured, and I can’t or won’t tell you how I’m investing your money. In fact, if I wish, I can change the investment strategy at any time without telling you! If things go well (for me – not you); I should end up with more of your money than you do in less than 20 years.

Are you interested? If this doesn’t sound like a great investment opportunity, then why are so many hedge funds popping up? What I have just described above is the business model of a typical hedge fund:

  • high fees, payable win or lose
  • minimal disclosure and lack of transparency
  • asymmetrical risk sharing
  • no reliable benchmarks against which the performance of your investment can be measured.

Having been involved in providing consulting advice to pension funds for almost 40 years, I have seen a lot of investment products – both good and bad - come and go over that time. Such “investment opportunities” as protected equity funds, index-linked products, and several generations of engineered products have come and gone. Overlays, swaps, derivatives, portable alpha – you know the stuff! But, in my opinion, one of the most ill-suited of all for pension funds is hedge funds. I welcome this opportunity to speak to you today on Hedge funds, and why, in my opinion, I think that pension funds, for the most part, should not invest in this “asset class”. This is not to say that all hedge funds are completely without merit, or that perhaps individual investors should not invest in them or why 95% of them tend to give the rest of them a bad rap.

My remarks today rather are limited to those pools of assets that are invested for and on behalf of the broader beneficiaries of pension funds, endowments and the like.

Let’s start with a definition of a Hedge fund:

"A hedge fund is a private investment vehicle for institutional investors and high net worth individuals. In the US, the SEC regulates the hedge fund sector minimally. The number of investors in a hedge fund is generally limited, and any individual investor in a hedge fund must be an accredited investor. Critically, the hedge fund avoids the SEC’s prohibition against the asset manager’s compensation being linked to fund performance, as is the case with, for instance, a mutual fund. For this reason, the hedge fund is often regarded as primarily an innovation in fund manager compensation. The hedge fund has no restriction on investment strategy. The hedge fund can change its strategy at will, but many characterize themselves according to a fixed style they do best.”

A somewhat less flattering, but possibly equally valid definition is:

“Hedge funds aren’t investment strategies, but rather a method to monetize institutional investors’ greed, hubris and gullibility”.

Taking all of your money at once is called stealing; taking all of your money gradually over time is called a hedge fund. You may take your choice!
In my opinion, there are two principal differences between hedge funds and what I will refer to as “traditional asset classes”:

  1. The regulatory environment (or rather, the lack thereof) under which hedge funds operate
  2. The manner in which hedge fund managers are permitted to exploit the inefficiencies in global capital markets wherever they may exist, in order to achieve “absolute” returns.

Unlike traditional asset classes, hedge funds are permitted to “sell short” (ie sell a security that they do not own anticipating that it will drop in value) and use leverage. As we will see, both of these strategies can increase the risk of the underlying fund. The following chart (courtesy of Alliance Bernstein) summarizes many of the principal differences between traditional asset classes and a typical hedge fund. It is perhaps important to state that hedge funds, as I’m sure you are aware, are in fact a non-homogeneous array of various investment strategies that loosely share the characteristics that I described above in my opening comments: limited regulatory environment, global in reach, high fees and appallingly weak disclosure of information.

Adapted from: Ruff, John, and Daniel J. Loewy. What Lies Beneath: Navigating the Hedge-Fund Market. AllianceBern-stein LP. November 2006. 22.

First, let’s start with the case for hedge funds. The rapid growth in assets under management in hedge funds occurred during the decade of the 1990’s, and the early part of the 21st century. It was, in my opinion, driven in large part by a desire on the part of some pension plans, as well as other funds and individual investors to achieve one or more of the following investment goals:

  • an absolute rate of return, regardless of the direction of the capital markets
  • achieve equity-like returns with fixed income-like volatility, or
  • to invest in an asset class whose returns were (allegedly) uncorrelated with those of other traditional asset classes.

While these objectives may seem laudable, I suggest that such hedge funds may not be entirely suitable for the vast majority of Canadian pension plans. Let’s consider some of the reasons why I believe this to be the case.

1. Governance

How are trustees of a pension plan expected to perform their fiduciary responsibility and conduct due diligence on the fund managers when most of the strategies followed by the hedge funds and the actual holdings of the funds are often not fully disclosed? And when such disclosure is reluctantly provided on a “need to know” basis, it is often delayed. Experience suggests that governance of many hedge funds is weak, and in some extreme cases, nonexistent. Furthermore, valuation of the underlying assets is moot, and the structure of the fund can be complex. The strategies of the fund manager(s) are considered proprietary, and there is often only limited information available on the actual holdings of the fund. In one recent actual case, the manager only disclosed the fund’s holding after several requests to provide the information. Pension plan trustees expect and deserve better. If they are to fulfil their legal obligation to act as fiduciaries, they MUST have full and timely disclosure of investment strategies, transactions and fund holdings. Because of “capacity” issues, which I will discuss more fully later in this presentation, many hedge fund managers are reluctant to disclose their strategies, and consequently investors in these funds must make their investments based largely on faith, rather than knowledge. The manager will often focus on historical returns and expect the prospective investors to extrapolate those returns as sufficient information on which to commit funds.
In his recent book: “The Hedge Fund Mirage”, Simon Lack refers to an earlier work “The Hedge Fund Fraud Casebook” by Bruce Johnson in which he examines industry frauds from 1968 -2000 noting:

“...the very existence of such a book serves as a warning to all hedge fund investors. You can carefully analyze a manager’s investment process; consider the subtle ways that his inclusion in a portfolio of hedge funds will affect its return, Sharpe ratio, value at risk and other risk statistics... And hanging over the entire exercise is the inestimable possibility that it is in fact a “Potemkin” hedge fund, and the result may be a total loss...”

Bernie Madoff was not an isolated example – simply one of the largest, and currently best know.

2. Valuation and Determination of “Fair Market Value”

One of the requirements for registered pension plans in Canada, for the purposes of solvency valuations, is to identify a fair market value for all of the assets held by the pension fund. This can be problematic for any of the investments in the so-called “alternative” asset classes, of which hedge funds is one example. Not all of the holdings of hedge funds are fully liquid and readily marketable. The extent to which illiquidity is a problem will depend, in part, on the particular strategies employed by a particular fund (or fund of funds), with some strategies presenting a greater valuation challenge than others. When determining fair market value, the fund manager has an opportunity to introduce smoothing techniques which may result in lower volatility of returns than would otherwise be the case.

3. Lack of Transparency, Disclosure and Audit Requirements

A key distinguishing characteristic of the broad class collectively known as hedge funds is the general lack of regulatory environment in which many of these funds operate. While I will concede that the situation has improved somewhat since the “wild west” days some years ago, there is still less rigorous audit requirements imposed on hedge funds that on other traditional assets. Unlike their long-only non-leveraged (and arguably more boring) counterparts in “traditional asset class” space, hedge funds continue to operate in a largely unregulated environment. Consequently performance results, as reported by the fund managers, are not subject to the same high standards as most other funds.

4. Lack of Reliable Benchmarks for Performance Measurement Purposes.

The following quote by Pravin Shah is noteworthy:

“Without a yardstick, there is no measurement. And without measurement, there is no control.”

Literature tells us that in order for a benchmark to be used to assess performance of a particular asset class, it must have the following characteristics:

  • it must be disclosed in advance
  • it must be reliable
  • it must be investable.

The Dow Jones Credit Suisse (DJCS) Hedge Fund Index only satisfies one of these criteria. Much has also been said about two of the key problems with any index – survivorship bias and the effect of “back fill” of data. More will be said about this when we get into the issue of performance. Suffice it say for now that hedge funds lack any reliable index against which the performance of any particular manager can be measured. Two often cited limitations on hedge fund performance indices are:

  • Many hedge funds go out of business, and as they do, their bad performance is not recorded and often lost
  • Hedge funds with good performance give data bases their early performance. Bad early performance does not get recoded.

One could also question how useful any such index would be as it relates to hedge funds. With traditional asset classes, we expect that the managers will be investing a homogeneous asset. For example, Canadian equity managers can reasonably be expected to be measured against the TSX index as a reliable measure of their performance since they are likely investing their assets, or at least a large portion of them, in Canadian equities. As far as hedge funds go, no one single index is representative of all the various strategies which managers could use, the use of a single index has its limitations.

5. Use of Leverage and Short Selling

These are perhaps the two main features of hedge funds that separate them from traditional “long only” asset classes. The use of leverage is obviously a double edged sword, and is one of the key contributors to sometimes impressive returns. But in many instances, of which we are unfortunately all too familiar, it has been the source of undoing of a hedge fund as leveraging can amplify both gains and losses. It can be argued quite legitimately that other asset classes employ leveraging to some extent; notably, real estate. When a pension fund invests in real estate (either directly or through participation in a pooled real estate fund), they are likely (and knowingly) being exposed to leveraging. However, the extent to which the properties are leveraged is invariably disclosed to the investor and incremental appreciation of the investments often reduces the exposure. The same cannot be said for hedge funds. Short-selling – the ability to attempt to identify an underperforming asset, and sell it without actually owning it, has also been a key strategy used by many hedge funds. It is an integral part of long-short strategies as well as market neutral funds. As with leveraging, the use of short selling has the potential to compound losses when the strategy fails.

6. Exactly what is a “Hedge Fund”?

The term “hedge fund” has been used to describe a non-homogeneous array of investment strategies, all of which (rightly or wrongly) get lumped together for discussion purposes. They range from the long/short fund (which enjoyed some popularity a few years ago as the 120/20 or 130/30 funds) and market neutral strategies to convertible arbitrage as well as so-called “event driven” and directional strategies. It is a very mixed bag that requires a wide array of skill sets by the investment managers ranging from traditional stock picking to quantitative analysis to macroeconomic theory. Comparison of results of individual managers is difficult, if not impossible, given the numerous variables involved.

7. Complex and Expensive Fee Structure

Perhaps the one thing that most people know about hedge funds is their fee structure. With individual funds quoting a fee of “2% plus 20% of profits”, and fund of funds charging an additional fee on top of that, it doesn’t take very long for your assets to transition to the fund manager. While it could, and often is argued that you “get what you pay for”, historical results do not support that thesis. How can prudent trustees of a pension fund justify the payment of 10 or 20 times the fee that they would normally pay for traditional long-only management on the faint hope of an “absolute” rate of return? It makes no sense to me! Even the somewhat popular “130/30” funds, which allow a manager to have up to 30% of the portfolio in “short” positions, with a corresponding increase in the “long” strategies has a fee structure more akin to a hedge fund than to a 100% long only fund, with a 30/30 market neutral add on. This is yet another example of the added cost of packaging! Historical results of hedge funds with which we are all familiar do not, in my opinion, justify the high (one could argue, exorbitant) fees that are charged by these funds. While admittedly some hedge funds (net of all fees) have produced awe-inspiring returns for their early investors, regrettably, an equal or greater number have not. And with over 8000 hedge funds from which to chose, it is a near impossibility to select the “winners”. Recent studies of hedge funds returns during the period from 1996 – 2005, found returns of 16.64% per annum (after all fees). However, when this return was adjusted for survivorship bias, the resulting return was reduced to 13.9%. Furthermore, when this return was adjusted for the effect of “backfill”, the net return was found to be only 9.6%. This return was then deconstructed into two components: alpha (or manager skill) and beta (the market return) resulting in 3.7% for the former and 5.4% for the latter.

A recent article in the Toronto Globe and Mail by columnist Norman Rothery made the following observation:

“I fully acknowledge that some hedge fund managers are brilliant and a few are able to more than make up for the fees they charge. Problem is, the fee hurdle is gigantic and the majority simply can’t surmount it.”

8. Level of Understanding Required by Trustees to Properly fulfil their Fiduciary Duty

In most instances, the level of understanding required by trustees of a hedge fund strategy is disproportionate with the potential for incremental returns resulting from using that strategy. Trustees, as I have now discovered first hand, have enormous responsibilities placed on them, both in law and in practice. Understanding all of the potential risks inherent in making an investment in hedge funds is disproportionate with the potential for additional returns and/or risk reduction that may be possible from investing in that asset class. The definition of “fiduciary” requires trustees to “...exercise care, diligence and skill in dealing with the property of others based on skills that they possess or ought to possess”. I would suggest to you that trustees of most pension plans, and multi-employer pension plans in particular, have sufficient matters to concern themselves with without delving into the morass know as hedge funds. Furthermore, from a purely practical point of view, the amount of time necessary to devote to obtain the necessary knowledge and understanding of the risks and rewards inherent in hedge funds would, as I have stated, be disproportionate with the amount of assets that would likely be allocated to these strategies. In my opinion, the time of the trustees could be better spent pursuing other issues.

9. Are results really uncorrelated?

Another reason often put forward by hedge fund managers for investing in their funds is that, based on their data, the performance of such funds tend to be uncorrelated to returns from more traditional asset classes. Thus, investing in hedge funds they would argue is a means of reducing overall portfolio risk. On closer examination, however, this turns out not to be the case as several recent studies have shown. In fact, during the economic crisis of 2008, it was found that hedge funds failed to provide the diversifying effect that they had claimed, and many suffered returns in line with the broader equity markets. The alleged lower volatility of hedge fund returns is a myth, as very often not all assets within the investment fund can be accurately priced, leading to a smoothing of values, and ultimately to lower volatility of returns. Investment returns of hedge funds are very manager specific, suggesting that skill, or more precisely, continuous skill of the manager is essential to a successful hedge fund. This is the case much more so than with investments in traditional asset classes.

10. Other Thoughts

As we have seen, the “manager dependency” factor may account for only as little as 20% of a traditional equity manager’s return, while the market itself is probably responsible for about 80% of the return over time. The percentage for fixed income funds is even greater with well over 90% of the return resulting from the market. Thus, the decision of which manager to hire, while arguably an important decision, and a considerable source of revenue for many investment consultants, it is secondary to the decision to invest in that asset class at all. This also partially explains the popularity of indexed funds – a low cost alternative to active management. On the other hand, a manager’s skill set is, in my opinion, the greatest single determinant of success when investing in hedge funds, as there really is no well defined “market”. The ability to successfully identify a hedge fund manager who will excel prospectively is, I suggest, if not impossible, at least very difficult. For this reason, the “fund of funds” approach to investing in hedge funds has gained popularity so that no single manager has the responsibility to carry the success of the fund. But such funds of funds come with a heavy cost. The impact of manager skill should not be underestimated. Most “successful” hedge funds have achieved that success based on the abilities of an individual or group of individuals who have been able to produce strong consistent positive returns over considerable time periods under various economic conditions. Unfortunately, once they have been identified by the world at large, it is probably too late for the investing world to benefit from their superior skill. Many of their strategies have limited capacity, and performance tends to wane as assets increase. Studies have shown that, as hedge funds mature and grow their assets; their ability to continue to perform well is diminished. Thus, the task is to identify managers – without the benefit of an historical track record – who can achieve superior returns over time.

In his recent book: “The Hedge Fund Mirage – The Illusion of Big Money and Why It’s Too Good to be True”, author and former hedge fund manager Simon Lack makes the following observation:

“Broadly speaking across the breadth and history of the hedge fund industry, investors have not fared well. The amazing result is that if all of the money ever invested (in hedge funds) had instead gone into Treasury bills, the investors would have been better off... Poor timing, weak analysis and hefty fees have all contributed to this outcome”.

He further goes on to ask the following questions – questions to which I for one would like to hear the answers:

The questions the industry should ask itself include:

  • Why have overall results for clients been so poor?
  • What is an appropriate fee model that is fair for clients but appropriately rewards high-decile investment performance?
  • What rights over transparency, liquidity and governance should investors demand from their hedge fund investments?
  • Are the results likely to persist in the future?”

The author goes on to say: “These issues are worth examining, because it is not as if hedge funds haven’t made money. They just haven’t passed those profits back to their investors. There is no shortage of immense investment talent available, although there is almost certainly too much capital in hedge funds today for the available opportunity set.”

Recent Developments

I recently attended a debate held in Toronto between Ira Gluskin, co-founder of the investment management Gluskin, Sheff, and Donald Raymond, Chief Investment Strategist and Senior Vice-President of the Canada Pension Plan Investment Board – the entity that manages about $200 billion on behalf of Canadians – including about $14 billion in hedge funds or about $800 for every Canadian. They were debating the merits of hedge funds as investments which “everyone” should own. After much posturing, the best thing that could be said about hedge funds is that they were excellent vehicles – for investment managers!

To quote Don Raymond (who by the way won the debate):

“Many hedge funds don’t hedge, returns are probably overstated, given self-selection and the risks are almost definitely biased downward thanks to the complexities involved in valuing illiquid assets. Investors have a hard time determining what true alpha rather than exotic beta is and thus are being overcharged for what they could get cheaper elsewhere such as in an ETF.”

A large international consulting firm recently held a “roundtable” forum on the use of alternative investments by Canadian pension plans and concluded that, when compared with their foreign counterparts; Canadian pension funds invest less in alternative assets. The exposure of such funds – mainly larger ones – is primarily into real estate and infrastructure, with exposure to hedge funds being quite limited. The presenter opined that the reason for this is that Canadian funds were more cautious and conservative. I would argue that we are simply just smarter!

In summation, if individuals are so inclined to allocate all or portion of their savings to a hedge fund, may they do so with their eyes wide open. The money that they are risking is their own. However, for trustees of pension plans, who are acting on behalf of the many beneficiaries of the retirement fund, I hope I have successfully demonstrated that, for many reasons, I find such funds to be wholly unsuitable. I don’t expect to earn praise from the managers of such funds, and perhaps I will be deleted from their electronic Christmas card list! This is the price I pay for speaking the truth!