Vol.27 - Hedge Fund Strategies Explained II

Hedge Fund Strategies Explained II
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By MSS Capital, | September 22, 2005

Investing in Hedge Funds
Hedge funds have become a core asset class. The explosive growth of the alternative asset management industry over the last few years has thrust hedge funds to the forefront of investors’ minds. The growth of the hedge fund sector has coincided with an economic and financial market environment that is one of the most challenging in recent memory. Despite this, hedge funds remain one of the most consistent performing asset classes within the entire spectrum of investment opportunities.

The performance of hedge funds compares favorably with traditional asset classes such as equities and bonds. Since December 1997*, global equities have returned an annualized 3.3% (FTSE All-World Index), global bonds an annualized 6.8% (JPM Global Bond Index) and hedge funds an annualized 8.5% (FTSE Hedge Global Composite Index). More impressively, hedge funds achieved this superior performance with just 3.9% annualized volatility, which is significantly less volatility than equities (15.7%) and bonds (7.1%).

Once investors have defined the objective they wish to achieve from investing in hedge funds (whether it be a target risk-adjusted return or exposure to specific strategies) and decided their investment parameters, they are then faced with the daunting task of fund selection.

The analytical process that leads to the selection of hedge funds is both quantitative and qualitative in nature. On the quantitative side, one must evaluate historical performance (absolute, relative to peer group and benchmarks), portfolio volatility, risk-adjusted return measures, drawdown history and assets under management relative to strategy being pursued. On the qualitative side, one must conduct a thorough analysis of the hedge fund’s lead portfolio manager and investment team, the corporate structure of the management company, the investment process being applied to markets, the portfolio characteristics and the risk management function. On the structural side, one must look at fund domicile, fund size, fee structure, subscription/redemption terms and associated parties. Once all three areas have been evaluated to the investor’s satisfaction, a decision can be made on allocating to the fund. Ultimately, investors seek to invest with experienced, high quality managers who have a thorough understanding of their investment process and its implementation to markets in the pursuit of absolute positive risk-adjusted returns, within a solid business framework. Managers who persistently breach their investment parameters and risk guidelines, inducing style drift, are to be avoided.

Investors can establish an exposure to hedge funds by either allocating directly to individual funds, investing in an actively managed fund of hedge funds, investing in an investible hedge fund index investment vehicle** or investing in a structured product with any of the previous three as an underlying.

Allocating directly to individual hedge funds provides the purest form of exposure and the investor remains in full control of his/her investment choice, allocation and timing (subject to the liquidity provisions of the funds in question). However, with over 6,000 hedge funds in existence, located globally and applying a wide range of investment strategies to financial markets, the task of successful fund selection poses many challenges. The research and due diligence that needs to be conducted in order to successfully make an investment is exhausting, time consuming and resource intensive. Furthermore, owing to wide variation in minimum investment sizes, allocating to a single manager requires significant sums of money without which the potential benefits of diversification are reduced and may expose investors to a significantly greater level of business and investment risk.

Allocating to an actively managed fund of hedge funds delegates the strategy allocation, fund selection process and day-to-day management of the portfolio of hedge funds to a third party organization that has experience of operating in the sector. The portfolio of hedge funds that investors buy into will typically be diversified across several of the mainstream strategies and invested in 20-plus funds. Investors additionally benefit from professional management of the hedge fund manager interface and lower minimum investment sizes. However, the cost of obtaining exposure via this route is substantial as both the underlying managers and the fund of hedge funds manager charge management fees and performance fees, thus creating a double fee structure for the investor, which can be difficult to tolerate during periods of poor performance.

Investible hedge fund indices aim to provide a daily measure of the aggregate risk and return characteristics of the broad-based universe of open liquid investible hedge funds in a representative, diversified, transparent and evolutionary manner. Their underlying investment vehicles are typically based on FoF models and seek to deliver the performance and returns of the target universe through creating a portfolio of hedge funds in strict accordance with the relevant index methodology and ground rules. When investing through an investible hedge fund index investment vehicle, investors benefit from a clearly defined rule structure that is applied to the universe of hedge funds in order to select individual funds; a portfolio of hedge funds that is well diversified across the mainstream strategies and is typically invested in 40-plus managers; a high level of transparency and strong risk management at a manager level due to the investments being made typically via the managed account route; attractive liquidity; and a non-skill based fee structure that entirely removes the second layer of performance fee associated with actively managed FoFs.

Structured products seek to tailor an underlying hedge fund exposure’s risk and returns to the investors’ specific needs and requirements. This very often takes the form of capital protection over a specified period or a guaranteed return profile. Investors are typically locked-in to these products for a minimum period of time in order to receive the protection (with reduced protection for early exit). Whilst the capital protection element to the structure is attractive, the cost of this is that investors do not necessarily receive the full positive performance of the underlying hedge fund exposure.

A Vibrant Industry
The net inflows into the hedge fund sector have been significant over the last few years as investors recognise the diversification “free lunch” and absolute positive return benefits hedge funds can deliver. These net inflows show few signs of abating any time soon. All four of the above hedge fund investment routes have enjoyed large inflows as investors entering the sector have matched their investments in accordance with their specific objectives. This has led to a substantial increase in the number of hedge funds and fund of funds in existence, with traditional fund management companies and investment banks loosing talented staff to the hedge fund sector. A polarisation of the sector has come about, whereby the large hedge fund organisations have been successful in attracting even more capital, whilst the small and medium-sized funds have typically found it more difficult growing their businesses. This does not mean, however, that small equates to poor quality, and with so many hedge funds in existence globally, the research and due diligence function is critical in successful manager selection.

* FTSE Hedge Index Series, net of fees, 31st Dec 1997 to 30th June 2005 (pro-forma figures prior to April 2004)

** The FTSE Hedge Index Series is investible via the FTSEhx Fund SPC

MSS Capital Ltd
Sridhar Venki - Investment Manager
Simon Hookway - Chief Investment Officer

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