Hedge funds: Old paradigm or new?

(October 7, 2003) There is a kind of folklore to the modern history of investing. First, at least for private clients, there were the trust departments of the banks, through the 1930s to the 1950s and later, which invested money with the aim of making an actual return. They may have made money, but not very well.

Then came Modern Portfolio Theory, which evolved into benchmarking returns against some standard, like the S&P 500. The benchmarking movement gathered speed through the 1960s and 1970s, and the orthodoxy and clients thrived — as long as the benchmarks did. In more recent times, hedge fund managers have again pushed absolute returns to the forefront, which may mark a return to the past or signal a shift to a new, loss-avoidance paradigm.

“There was an asset investment industry before there were benchmarks,” says Alexander Ineichen, global head of alternative investment strategy research at UBS in London and author of the book Absolute Returns. What changed was that benchmarking produced a new definition of risk — failing to hew closely to the returns of what a benchmark like the S&P 500 yielded.

Speaking at the Strategy Institute’s annual conference on alternative investments for institutional investors in Montreal late last week, Ineichen outlined one reason behind the shift to benchmarking. Discretionary money managers in earlier periods cleaved to absolute returns, but weren’t particularly specialized, investing in a whole gamut of securities from stocks to bonds to cash.

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However, changes in U.S. pension legislation in the early 1970s ushered in the “relative performance game.” Benchmarks made performance measurable, and at the same time “there was a strong demand from investors to hold a manager accountable for performance,” and benchmarks supplied the measuring stick. Accompanying that movement was greater specialization — or fragmentation — of portfolio managers, each answering to a different benchmark, be it equities, small caps, emerging markets or bonds.

Now, “if you combine an absolute return approach with a high degree of specialization, you’ve actually got what we today call a hedge fund,” he adds. But it’s not about returns; it’s about risk.

The relative return manager is concerned with only one risk: tracking error, or deviations from the benchmark, Ineichen argues. The absolute return manager, by contrast, attempts to mitigate total risk: loss of capital. In the former, the goal is to beat the benchmark and capture the asset class premium: the reward for investing in a risky asset. In the latter, exploiting the investment opportunity while preserving capital is the goal.

On another level, what the relative return manager gives to the investor is a normal distribution of returns — the bell curve of the market performance over time with all its ups and downs. That is “risk-neutral” and while the manager delivers the symmetrical distribution of returns to the investor, “it’s up to the investor to manage the risk through asset allocation,” he comments.

On the other hand, the absolute return manager tries to deliver an asymmetrical distribution of returns — more upside than downside — by managing against a quite different benchmark: cash. The risk-neutral position for a hedge fund is the performance of cash, and that definition encompasses total risk, or the risk of actually losing money, not the relative risk of underperforming.

One reason is that the hedge fund manager’s own compensation is determined by their profit and loss. They have an incentive to skew the return distribution — the bell curve — to the right-hand or profitable side; otherwise they, too, lose money.

In comparing the benchmarks to select hedge fund indices, Ineichen finds that “the swings on the upside are similar” — investors don’t give up much in the way of returns — but quite drastically different on the downside. That puts the whole concept of risk as volatility into question. Upside volatility benefits the investors. The superior past performance of this asset class, he cautions, doesn’t necessarily come from making money when the wind comes from behind; it’s really coming from preserving wealth when the wind changes.

“I think risk management really has to deal with change, because once you notice that your investment process doesn’t work, you react to that change because every strategy has its time… There will always be periods where a strategy works better and periods where it works less well,” says Ineichen.

Hedge fund managers, he argues, have a mandate to react to that change because they are managing total risk, whereas relative return managers do not.

Still, Ineichen notes, active management isn’t necessary to achieve an asymmetry of returns skewed to the right or, in other words, to manage total risks. One could buy a strip bond, and put the remaining money into a call option on the S&P. Capital is protected, and total returns depend on whether the call option is in the money or not — i.e., whether the S&P 500 rises. If it doesn’t rise, the option expires worthless, with the investor out of pocket only for the option cost. If it does rise, the investor captures the S&P gain, less the cost of buying the option.

Such a strategy would not have matched the S&P 500 years in its peak years — there is an opportunity cost for a principal guarantee — but through the 1990s into 2003 it would have yielded 8.4% annually versus an S&P return of 8.6%. Such a strategy would also be treading water now, compared to its earlier peak, whereas the S&P is still about 40% off its high-water mark. “If you were a loss-averse investor, that is the kind of investment you would have had a preference for,” Ineichen says.

In this, Ineichen senses what may be a paradigm shift in the investment industry.

“Throughout the 1990s, there was a belief that for equities, you were indifferent to volatility because you were a long-term investor, which means that you can stomach volatility,” he explains. “A lot of people, investors and institutions alike… are questioning that, meaning you are not indifferent to volatility. I think, for example, pension funds, who had their surpluses wiped out in a fairly short period of time, are reassessing the anguish they want to take.”

“Investors are loss-averse to a certain degree, which means they are not indifferent to these extremes on the downside,” adds Ineichen.

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Filed by Scot Blythe, Advisor.ca, sblythe@advisor.ca.

(10/07/03)