Hedge fund targets shift in secular bear

(November 18, 2004) Advisors and clients need to better understand the nature of hedge funds before investing in them as the latest “hot trend,” according to a leading advisor in the hedge fund field. Hedge funds have their place in protecting investors from today’s secular bear market, but only if they are properly understood.

In a secular bear market, the goal is not to beat the market so much as to avoid losing money. This is where many investors go wrong, according to John Mauldin, president of Millennium Wave Investments, speaking to the Strategy Institute’s Alternative Investments for HNW Investors conference in Toronto. Too often the market is seen as the “beta” or benchmark against which returns are measured.

“Their peers are really their beta, that’s what they’re measured against,” Mauldin says. “In a secular bear market, our bogey isn’t the stock market; it’s zero. You’re looking for absolute returns; you don’t care what the market does. I don’t care what the market does. Are you compounding my money at a reasonable pace?”

He says there are three key questions an advisor needs to ask when considering a hedge fund: Why does this fund make money; how does it make money; and who is managing the fund?

“There are a lot of hedge funds that are just lucky — they were in the right place at the right time,” he says. “What you want to do is look at the past performance numbers and ask: Did these guys really do something extraordinary?”

When comparing performance, the investor is really looking at how consistently the manager has been able to outperform their beta.

Understanding Alpha

Alpha is the value a manager is able to add above the beta measurement. Mauldin likens alpha to a swarm of bees: Despite appearances, the swarm is finite; it also moves, it hides and it shifts.

As an advisor, he points out it is his job to identify the managers who can offer his or her clients with the most alpha. And the best place to find this is within small, nimble niche plays, where the larger hedge funds are unable or unwilling to participate.

“Alpha doesn’t sit still,” he says. “We can’t say ‘I found some alpha,’ invest in a fund and expect it to be there in five or 10 years, especially if the manager doesn’t shift how he’s going after that alpha.”

Concern over manager’s style drift may be well founded in the mutual fund industry, but Mauldin says he is more concerned when a hedge fund manager does not demonstrate any style drift, since ever-changing market conditions require varying strategies.

“I want my managers thinking. I want them figuring out where the market’s moving and trying to stay ahead of it,” he says. “If they’re using the same system today as they were 10 years ago, their returns have probably dropped.”

He says a fund of funds that has earned 5% over the past year will be in the top 10% of that category.

Current conditions

Right now is an excellent time to consider various hedging strategies. The stock markets (especially in Canada) have spent the past two years rebounding from their lows and investors may be regaining their confidence.

But Mauldin says market conditions are not favourable in the short or mid-term, with U.S. markets on hold waiting for the next recession. Secular bear markets all begin in periods of high PE ratios. In historical terms, U.S. stock markets are currently in the top 20% of years with high PE ratios, Mauldin says, pointing to stocks such as Google, which is trading at 15 times sales — never mind earnings.

Over the next 10 years, investors could still realize negative returns if they bought and held at today’s valuations.

“When we’re in the most expensive 20% of the time, your returns for the next ten years are zero,” he says. “There are lots of 10-year periods in history where the markets don’t compound.” In fact, staying invested for 20 years is no guarantee of positive returns if an investor starts at the wrong point in the cycle.

Since secular market cycles take about 18 years to play out, now is not the time to be “long only” on stocks or bonds. Based on historical trends, it is likely that stocks will be trading at a 40% discount in two or three years, representing an excellent opportunity for investors who manage to preserve their capital until that time.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/18/04)

Steven Lamb