Investing dynamically with hedge funds

Hedge funds have an unconstrained and opportunistic investment mandate. This flexibility is based on a dynamic investment approach that focuses on generating returns in myriad and diverse investment environments, changing market conditions and specific opportunities including market dislocations, corporate events, security mispricings, directional bets, arbitrage, and trend-following, to name a few.

Hedge funds can, in most cases, radically adjust market risk to respond to occurring or anticipated events and shocks by dramatically increasing or reducing portfolio risk. These attributes suggest hedge funds can benefit from an infinite set of opportunities in the global markets and should be considered a key portfolio holding if an investor wishes to profit from a multitude of investment opportunities.

Canada’s public and provincial pension funds have been long-standing investors in hedge funds with some 4% of portfolio holdings allocated to them. Historically, however, Canadian private investors have not been a significant follower of hedge funds, especially when considering the prevalence of hedge funds in the portfolios of global investors. Fortunately, this seems to be changing as investors become more familiar with this flourishing investment class.

Hedge funds have been in existence since 1949 when Alfred Winslow Jones, previously a journalist for ‘Fortune’ magazine, launched an innovative long/short equity fund. Jones hedged out market risk by shorting the stocks of what he perceived to be weak firms whilst simultaneously purchasing stocks of companies he felt would do well. Short-selling, it should be noted, has been around for centuries. This “hedged” investment approach reduced overall portfolio risk which meant that Jones could utilize leverage to enhance returns. Although Jones kept a low profile, a 1966 ‘Fortune’ magazine article brought him fame and recognition. ‘Fortune’ revealed Jones had outperformed the leading mutual funds by a wide margin. In 1966, he beat the best mutual fund by 44% and over the preceding five year period by 87%, net of all fees.

Although hedge fund managers employ complex investment strategies, the benefits to an investor are straight-forward. One of these benefits is a reduction in expected loss through the potential to earn profits in declining markets. Another benefit is the elimination of market risk through the application of a long/short hedged strategy. And yet another benefit is the ability to provide protection in times of crisis is by “going long” volatility which tends to spike up during periods of uncertainty. Regrettably, because some in the traditional investment community and media are not very familiar with hedge funds they consider them to be unsafe investments. This couldn’t be further from the truth.

The size of the Canadian hedge fund industry is significant at approximately $30 billion but small relative to the larger global hedge fund industry with circa $1.5 trillion in assets. The New York City-Connecticut corridor is the hedge fund capital of the world. Together with London and Switzerland, the traditional source of private client hedge fund investment, these three centers manage most of the world’s hedge fund assets.

I hope to be able to dispel at least some of the misperceptions about hedge funds in Canada by exploring the benefits of investing in hedge funds and by addressing their shortcomings. Let’s start by looking at the performance record of the global equity markets and hedge funds, a common comparison. Below is a graph showing the performance of global stocks over the past 10 years as measured by the benchmark MSCI World Equity Index.

This record provides a good framework from which to discuss hedge fund investing as there have been tremendous opportunities to make money from actively being both long and short stocks but none really by using a buy-and-hold strategy. Timing and direction have been critical to realizing any profits. Had you bought a diversified market-weight basket of global stocks at the end of 1999, you would be running a significant loss in your portfolio of about 20%. Cash would have out-performed this buy-and-hold strategy as your returns would have been positive.

Skeptics, however, would highlight the negative stock market environment during this period. Firstly, I would emphasize that it is widely accepted that the past 10 years was a period of substantial investment opportunities across most assets including stocks, bonds, real estate and commodities. Interest rates were low, credit was readily attainable, markets were booming. There was, however, a tech market bubble which exploded in 2000 that led to a bear market in stocks, but even if we reach back to the end of the previous crisis in 1998, the return on a portfolio of global stocks would have struggled to breakeven. This period includes the massive equity rally at the end of 1999, what still holds as the peak of a long-term bull market that started in 1983.

Secondly, 10 years is a significant period and thus classifies as the “long-term” even if it doesn’t exactly coincide with the definition academics use when they talk about investing (Roger Ibbotson famously showed that since the late 1920’s, stocks have returned circa 10% per annum). If markets are going up without a major decline, then time is less of an issue because you are comforted by the knowledge that your net worth is increasing. However, when stocks experience a significant and extended decline, the concept of time suddenly takes on a real and relevant quality as your need for capital in times of trouble rises whilst the value of your capital declines. It is precisely in this negative environment that we realize that we are just not able to wait for the “really long-term” for markets to recover. Bear markets have a rather impolite tendency to occur just when you don’t need them.

Next, let’s look at the performance of hedge funds over this same period. In the graph below, I added the performance record of the hedge fund industry as measured by the benchmark HFR Fund Weighted Composite Index, one of the oldest and most-quoted hedge fund indices. In Canada, RBC and Scotiabank produce two hedge fund indices: RBC has an investible global hedge fund index and Scotia maintains a hedge fund index based strictly on Canadian hedge funds.

Hedge fund managers have an unconstrained investment mandate which gives them tremendous flexibility in how they invest enabling them to exploit opportunities that are not available to the traditional investment manager. The need for markets to rise is less important to a hedge fund manager than it is for the traditional buy-and-hold manager. Hedge funds can and do benefit from rising markets, but they are also able to profit from declining markets by “going short”. Hedge funds, not unlike traditional investors that buy stocks on margin, can also use leverage to increase returns but typically leverage is, contrary to popular belief, quite low in most investment strategies. Moreover, hedge fund managers and their employees are normally one of the largest investor groups in their own funds ensuring that their interests are directly linked with those of their investors.

However, because hedge fund investing requires considerable skill and experience, there is a wide dispersion in performance across the manager base such that only some managers have been able to produce consistent returns over varying market environments, whilst others have floundered or fallen. Selecting the right manager, therefore, is essential. This applies to both hedge fund and traditional investment managers. The performance of hedge funds, however, is not substantially as a result of “being long the market” (the returns available from owning stocks by simply being invested in the market – often called “beta”) like it is for traditional investment managers. It would be fair to say that the skill required to generate returns irrespective of the market environment is commensurately higher than trying to outperform on the upside when markets are in a bull run or to lose less when stocks are in a bear market. This is the challenge for the traditional investment manager, to out-perform the relevant benchmark index. The problem for clients is that in a declining market, losing less than the index is still a loss.

There are, of course, other important considerations such as integrity, expertise of team and operational structure, but skill and experience are ultimately what determine performance. In this regard, there is a significant difference in the returns of skilled managers with those that are less skilled. Below is the last chart in this series that includes the performance of several of the titans of the investment industry. These are some of the largest managers with some of the longest track records. The hedge fund titans and their flagship funds are (expressed as an equally-weighted allocation): Steve Cohen of SAC Capital, Paul Tudor Jones of Tudor, Israel Englander of Millennium, Bruce Kovner of Caxton, and Louis Bacon of Moore. Although there are certainly other hedge fund titans that can be included in this list, it is nonetheless a representative selection of the legends. Representing the titans of the traditional investment management industry (i.e. equity investors) is the legendary Warren Buffett of Berkshire Hathaway.

Hedge funds, however, are not absolute return investments as they have been overzealously marketed. Despite the fact that they are able to “go short” to benefit from declining markets and, in the case of hedged strategies, are able to eliminate market risk, they are nonetheless open to other sources of risk that can expose them to losses. These include funding and counterparty risk embedded in their use of leverage, and liquidity risk in times of crisis when there is a global rush for safety away from risk assets. A third risk that appeared by 2006-2007 was the overcrowding of trades: too much capital seeking too few opportunities in a crowded market. This risk grew in importance as the record low interest rate and easy credit environment of 2003-2007 led to a tremendous amount of risk capital being employed worldwide.

Hedge funds and their investment strategies, however, are not a homogenous lot. This heterogeneity is important because it suggests that you can combine them in such a way that as a whole, they perform strongly in both up and down markets, and potentially even in stressed markets. Hedge funds that benefit from periods of stress and crisis (i.e. short sellers, trend followers and long volatility strategies) should be a key holding in any well diversified portfolio of hedge funds. Properly constructed portfolios of hedge funds that maintain an allocation to these “protection strategies” will perform well over all types of market environments.

Hedge funds, with their ability to invest dynamically, are still not fully accepted by the general population. This is unfortunate as they have many beneficial qualities that should appeal to the investor. Nevertheless, like all investments, they are not risk-free, but they are also not as risky as many would have you believe. The complexity of hedge fund investing suggests that investors wishing to allocate to hedge funds should do so with the guidance of a skilled and experienced hedge fund practitioner. Hedge funds not only have a rich history but, more importantly, a bright future and merit a closer look by Canadian investors.

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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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