The Misperception with Hedge Funds
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Alternative asset managers "have survived market turmoil following last month's downgrades of Ford and General Motors", writes The Financial Times. Well, surviving market turmoil is sort of the point of investing into hedge funds worthy of the name, though it is evident that a number of managers - particularly in convertible bond arbitrage, managed futures and what is loosely called "credit" - are being taken out on stretchers; Bloomberg reports that GLG Managed Futures has been liquidated and that the $2 billion convertible-arb Marin Capital Partners fund is also to close. James Drummond for the FT suggests that even though the widely followed CSFB / Tremont index of hedge funds has recovered earlier losses and is now flat year-to-date, "investors would have done better to put their money in the bank in the first five months of 2005". If only perfect foresight were achievable. But then Pearson would also miss out on the £1 cover price of the Financial Times. Well, investors into the CSFB / Tremont index - if that's even possible - might have done better sheltering in cash, but then so might investors into the Dow (-2% at the time of writing) or the S&P 500 (-0.4%) or the Nasdaq Composite (-4.6%). And while "real results may be worse than indicated by hedge-fund indices" they may also be better - it depends rather crucially on the hedge fund manager and the fund.
Perhaps the biggest problem facing hedge funds is that the entire sector, despite its recent success in attracting assets, remains suffused with misperception, fuelled in no small part by excitable media which continue to report relatively modest mark-to-market losses as systemic crises. And one of the biggest misperceptions is that hedge funds represent some sort of homogenized asset class. The existence of hedge fund indices - with all their inevitable reporting imperfections - does not magically transform hedge funds as investments into a box-tickable asset class, whatever investment consultants may (or more likely may not) be thinking. There is, moreover, good reason to believe that as this multifaceted approach to investment risk and opportunity continues to steal market share either from indexers or more likely from traditionally constrained asset managers, it will fall prey to a growing number of hangers-on and intermediaries of dubious worth determined to impose upon it the sort of traditional constraints that have intellectually devalued the raison d'etre of traditional active managers.
Tim Hale of Albion Strategic Consulting recently wrote, on TheWealthNet, about some of the "easy ways to land in trouble with hedge funds". Hale started his list with "Thinking that hedge funds are a distinct type of investment, or asset class". This was swiftly followed with "Using sweeping generalisations without common sense". Cheap and cheerful rules-of-thumb, when deployed by asset managers, are sometimes known as heuristics. When deployed by journalists they become headlines. Which leads us to another of Hale's warnings: "Thinking that you can capture industry 'characteristics' easily". The human desire to simplify complexity is understandable, but there are obvious limitations within such a broad and diversified sector. Characterising the nature and track record of thousands of discrete funds where reporting performance of results is at the discretion of managers and where many funds are closed - due either to prior investment success or the precise opposite of it - is one of them. ("Believing the numbers" is Hale's seventh semi-legitimate caveat for potential investors into hedge funds.) One for hedge fund managers specifically: there is not much point worrying about hedging market risk when you have become the market, but that's a different story..
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Tim Hale also has the good grace to acknowledge that "There are undoubtedly a few (hedged) managers who outperform over long periods of time as a consequence of their superb skills." And in the interests of full objectivity, there are undoubtedly a few traditional asset managers who also manage to outperform over the long term on the basis of proprietary skills. One could argue that a key difference between the two sectors is that a mediocre hedge fund manager has a reasonable likelihood of delivering a positive return, albeit a small one, in any given year whereas a mediocre traditional manager may well deliver a substantial negative return in any given year depending on the behaviour of the equity or bond markets which he or she is obligated to track. Perhaps the asset management industry should spend less time on launching faddish products - with their own inevitable attrition rates - and more time on cultivating and nurturing skills among the employees on whom it is so critically dependent. There is a widespread presumption that new hedge fund launches are predicated primarily on the desire of asset managers to create wealth for themselves. It seems fair to presume that the desire to develop new talents in a less heavily constrained environment also plays a significant part. Not every aspirant hedge fund manager will succeed, of course, but there's no reason to presume that the figures on hedge fund start-up failures are markedly different from those of business start-ups more generally. Perhaps the financial press are simplistically treating non-homogenized hedge funds as the not particularly homogenized dotcoms of the new millennium ("beware this bubbly rush for self-aggrandizement," they appear to be saying, whilst paying less attention to the palpable investment industry failure that hedge funds are endeavouring to address). Even if the attrition rates for hedge fund start-ups turn out to be substantially higher than they are today, the investment management eBays and Googles will still be out there, slowly building momentum and assets, and directing money in its most productive and lucrative direction away from secular decline and toward growth, which is what capitalism is surely all about.
Tim PricSenior Investment StrategisAnsbacher & Co Ltd
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