Hedge funds are evil

You heard me. Hedge funds are evil. Don’t believe me. How about these sources…

“We cannot forget how in 1997-98 American hedge funds destroyed the economies of poor countries by manipulating their national currencies.” – Dr. Mahathir Bin Mohamad, the former Prime Minister of Malaysia commenting during the 1997-1998 emerging market crisis.

“The US Securities and Exchange Commission may ban short-selling in the shares of Wall Street brokerages after Morgan Stanley fell 39 percent this week, said a person familiar with the matter.”; “The SEC is weighing a more direct attack on the practice after New York Senators Charles Schumer and Hillary Clinton urged a ban, saying it would help restore stability.” Bloomberg – September 2008.

“As markets crumbled last year, regulators and lawmakers turned their sights on the shadowy world of hedge funds, lightly regulated investment pools that can engage in a wider array of transactions than closely watched mutual funds.” – Reuters, June 2009.

Let’s be clear about hedge funds. Their investment strategies are complex and thus often difficult to understand by the uninitiated. They are typically not very transparent when it comes to their portfolio holdings and their investment models. They can use leverage to augment returns; in many cases, they are not terribly liquid; and, of course, they charge high fees.

So, why invest in them?

Having read the above, most sane investors would simply say…No, not me. No way. Over the past 20 years that I have been involved in the hedge fund industry, I am used to the media describing the industry in an inaccurate manner. Typically, a news item or article will start with: “Hedge funds are lightly regulated investment vehicles”; and follow with: “The secretive world of hedge funds”; and will certainly include: “Hedge funds charge exorbitant fees which is why so many hedge fund managers are rich beyond belief”.

This type of sensationalism sells copy but it is a disservice to readers and potential investors. Hedge funds are an acceptable investment medium. They have been around for over 50 years but the process of hedging out risk has existed for much, much longer and is well documented. This includes short selling and borrowings (leverage).

It is true, however, that the hedge fund world is not generally transparent. Hedge fund firms are typically privately held so there is no onus for disclosure. The holdings and investment models employed by hedge funds are not available to outsiders, and many firms require employees to sign very restrictive non-disclosure agreements when they are hired.

It’s pretty easy to understand why they wouldn’t want their secrets divulged to the general public. If everyone knew how they invested and what they were holding, they would have no “edge”. Worse, the market could trade against them if ever they were perceived to be in a weak position. And, of course, there are plenty of copycat traders out there who would flood their trades.

I don’t recall Warrant Buffet ever giving out his trading secrets to all the investors that follow his every move. Consider as well that the government doesn’t provide its citizens with the blueprints to the stealth bomber either.

Yes, hedge fund fees are high. Will they decline soon, especially considering last year’s rout? The feeling is they will remain where they are, for the most part, until a much larger part of the investment industry is able to provide hedge-fund-like positive returns in down markets. Many smaller funds have lowered fees in an attempt to stay afloat and recapture the assets they lost in ’08, but the real players, the titans, the masters, the pros, these guys will continue to command a premium because even if hedge funds as a whole lost money last year, these players did far, far better with their skill and experience being the determining factor.

Let’s dispel another myth while we are at it. Hedge funds are not absolute return investment vehicles. A well diversified portfolio of hedge funds can provide a high probability for no year-on-year losses, especially if the portfolio holds strategies that perform well in crises such as long volatility, managed futures, and short sellers, but there will always be a time when even this bullet-proof portfolio will lose money. Call it the extreme event, the Black Swan. It’s not only out there. It actually happens fairly regularly.

The supposed one-in-one-thousand event happens a lot more often than the statistics suggest. Statistics are great at measuring the physical world but they are less capable of quantifying behavioral inputs. Human beings are substantially driven by psychological factors. It is very hard to take emotion out of the decision-making process. In fact, it’s probably impossible. We use computers in investing to not just crunch a massive amount of information but to remove the emotional component that weds a human being to a trade. It’s not about being right. It’s about making money. Leave the “being right” to the writers. Money managers need to make money and managing money is an emotional game. This should be fairly intuitive. If you lost money last year then you probably were pretty emotional about it.

Diversification is a good thing but it can be deceiving. It can lull you into thinking you are safe. From the stock market bottom in 2003 to the peak in 2007, most asset managers maintained diversified portfolios with investments across the asset classes and the various regions of the world. This is SOP, Standard Operating Procedure, and performance was strong as pretty much everything – correction, everything – was rising in price by the time 2007 rolled around; stocks, bonds, high yield bonds, emerging market bonds, emerging market equities, oil, almost all the commodities (lumber, it seems, did not go up), and, of course, real estate.

Diversification normally reduces returns on the way up but this time around, as everything was driven higher by a massive credit injection, it didn’t matter if you had your bets spread out across assets and regions, you made money, and plenty of it. However, when markets turned down, they all turned down, and diversification proved a false sanctuary. A crisis will do that. It will correlate all investments to one as there is a mass and simultaneous exodus out of risky assets and into the perceived safety of government bonds.

Cash is king in this environment…or is it? Cash will preserve capital (not always, scream the holders of the world’s oldest and largest money market fund, the Reserve Fund), but it won’t provide returns to counter-balance the losses in the rest of your portfolio. And it does have this pesky problem that your timing out of risky assets and into 100% cash would need to be just right (read, at the crest of the wave) so that your clients don’t fire you for potentially “losing” them all the further gains available from that rising market.

This is where hedge funds come in. Managed futures performed extraordinarily well last year during the crisis but it wasn’t alone. Short sellers, unsurprisingly, had a banner year. The big winner though was long volatility traders. This esoteric group of managers typically own options that benefit from rising volatility. Equity volatility, for instance, exploded higher from an all time low in 2007 (below 10%) to an all time high in 2008 (90%). Nassim Taleb of Black Swan fame is certainly the most visible of this select club, but many multi-strategy hedge funds also had long volatility trades on.

Hedge funds, in general, are net beneficiaries of volatility as they constantly seek out opportunities from dislocations. And the world has certainly become more uncertain and volatile, much more, in fact.

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Claude Bovet is the head of SFCS Capital, an investment management boutique providing alternative investment products and services through its offices in Canada and the Cayman Islands.

From 1997 to 2002, he was head of portfolio management and research and from 2002 to 2005 chief investment officer of the Bucephale Group. Claude created and managed the Bucephale Legends Fund, a multi-manager fund invested in the world’s leading hedge funds.

From 1993 to 1997, Claude was senior portfolio manager and member of the Investment Committee of Republic National Bank, Geneva, one of the world’s largest allocators to hedge funds and now part of HSBC. From 1989 to 1993 he was hedge funds product manager and financial consultant at Lehman Brothers and Merrill Lynch in Geneva.

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Claude Bovet