March 2002

Hedge Funds: The Most Misunderstood Asset Class

By Laura L. Carpenter

Opinions about the alternative investment category known as hedge funds have fiercely divided consultants, institutions, and even the media. Almost everyone has an opinion about them, but almost no one understands what they are or how they function.

Hedging has been traditionally defined as protection from some kind of downside risk. In the context of investments, hedging protects investors from declining markets. Hedge funds have an absolute performance objective, which means they emphasize absolute return as opposed to returns relative to a benchmark or index. Consequently, the work hedge fund managers do is usually considered more skills-based.

The reason for the level of negative publicity surrounding hedge funds is that limited understanding breeds uncertainty. For example, 1998 was a disastrous year for hedge funds. Russia had defaulted on its ruble and domestic debt. The stock market began to tumble, which sent panicked investors running to the fixed-income markets. To protect themselves from falling equity returns, investors bought up high-quality Treasury and other government bonds. As a result, credit spreads between high-quality and risky debt increased dramatically, reversing the narrowing trend. Many hedge funds that had bet on those narrowing spreads and were heavily invested in fixed-income securities suffered tremendous losses and were forced to liquidate, deleverage, or, ultimately, go out of business. Hedge fund lenders reduced their credit lines, further compounding the losses. If anything good came out of these events, it was that regulators and investors have kept a watchful eye on the hedge fund industry ever since. Hedge fund managers that quietly go about their work of creating investment strategies and opportunities aren’t very newsworthy, but speculative or even fraudulent hedge funds always make headlines.

Another common misconception about hedge funds is that, unlike traditional asset classes, not every hedge fund is interested in every investor’s money. Hedge funds tend to be selective. Capacity remains one of the largest internal barriers to opportunity for hedge funds because as a fund grows, its managers are often forced out of the very strategy that was crucial to performance. Ironically, large institutions have too much money to even be considered by an existing hedge fund manager because a large institution will reduce the fund’s capacity very quickly.

Hedge funds are attractive to investors because they have a low correlation to traditional asset classes. The low correlation comes from the manager’s ability to reduce risk by hedging, combining long and short positions, and diversifying across various financial instruments. But investors struggle with the fact that the hedge funds encompass many styles and strategies. Hedge funds don’t simply mean market-neutral or long/short strategies. Some strategies are driven by the same market forces as traditional investments and can be considered return-enhancers. Other strategies are relatively unaffected by the market factors that drive traditional investments and therefore are considered return-diversifiers.

Getting investors to focus on a hedge fund’s philosophy as much as they do on performance is difficult. But whether a potential investor is concerned about liquidity, lack of benchmark comparisons, classification in the investment policy, fees, or disclosure issues, extensive due diligence is the key to investing in hedge fund strategies. The hedge fund managers, documented processes, and guidelines are just as important as the returns, if not more so. Just as with traditional asset classes, diversification—spreading risk over various asset classes—is crucial to protecting the investor from devastating losses. Hedge funds are risky, but so is limiting investment opportunities strictly to traditional asset classes.

Using a fund of funds gives the investor access to a number of strategies. Fund of funds invest in anywhere from five to 100 funds with different strategies. The goal is to smooth out the volatility of investing in a single hedge fund. As with traditional asset management, an individual investment is typically dominated by a relatively narrow approach, and good performance is often the result of one or two key individuals. But by pooling various strategies, the level of risk for the portfolio of hedge funds tends to fall dramatically. This decreased risk reflects the very low correlation among different hedge fund strategies. A fund of funds is a very effective way for investors to gain exposure to a range of strategies without committing substantial resources to asset allocation, individual fund research, and portfolio construction. The product can be used as a bond or equity surrogate depending on the volatility of the underlying managers, and the investor can take advantage of an asset class with investment returns uncorrelated not only to traditional asset classes but to each other as well. A custom-built fund of funds can also create opportunities for large institutions that don’t have access to established hedge funds.
Institutional allocations to hedge funds and other alternative investments continue to increase in the face of negative publicity. As the volatility subsides, and as traditional equity and fixed income returns migrate back to their long-term averages, more individual investors, institutions, and fiduciaries will search for ways to diversify their risk. They may want to educate themselves about hedge funds and their advantages.

Laura L. Carpenter is a senior analyst at Innovest Portfolio Solutions, a Denver-based firm serving retirement plans, nonprofits, and wealthy families.

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