The rationale for investing in hedge funds is straightforward: to take advantage of probably the only free lunch in portfolio management - the ability to add riskier, and therefore higher returning, assets to a portfolio while actually reducing the volatility of the portfolio as a whole.
This is possible because of a lack of correlation between the returns of most hedge fund managers and U.S. public markets, where the largest portion of most pension plans and endowments is invested.
Vassar College is invested in three large hedge funds, comprising roughly 11% of our $400 million endowment - a larger commitment than 90% of our peers. Since our first foray into hedge funds more than four years ago, our actual allocation has ranged from 10% to 16%.
Originally viewed as an equity alternative, hedge funds were formally incorporated into our long-term asset allocation policy in January.
Our goal is to diversify the portfolio in a manner that increases returns while simultaneously reducing risk.
From the experiences of the past several years, I have come to believe institutions should focus on several important factors when analyzing current or prospective hedge fund investments.
Type of fund
Many different strategies are included under the umbrella of hedge funds and they fall across the entire risk/return spectrum. These strategies range from unleveraged, long-short managers who seek to add value to a cash benchmark to global, macromanagers who make large, leveraged bets in any area where they perceive value.
This latter type of fund cannot be considered "hedged" by any stretch of the imagination, but the expected returns are quite high.
Funds also may specialize in distressed securities, merger arbitrage, short-selling or other non-traditional strategies.
What most hedge funds have in common is the expectation that their returns will not be highly correlated with those of other asset classes.
Realistic expectations
Investors must keep in mind a cornerstone of investment theory: There are no greater returns without greater risk. Do not expect a conservative, truly hedged, unleveraged fund to earn 20% per year.
Conversely, do expect significant fluctuations in returns from a manager that is seeking to earn returns of 20% to 25% per annum. Look past the fund's marketing hype and recent performance figures and make sure you have realistic return expectations and the appropriate risk tolerance for the type of manager hired.
Appropriate benchmarks
Hedge funds generally are expected to produce solid returns with little correlation to public markets. Therein lies their diversification appeal. However, this also implies a benchmark composed of a stock or bond market index such as the Standard & Poor's 500 Stock Index is generally inappropriate.
If a fund follows a narrow strategy, a specific benchmark related to that strategy might be available and relevant.
But for hedge funds that pursue a wider variety of strategies, a better alternative is simply to use your expected return as the manager's bogie. If you expect 15% annual returns net of all fees from a manager, use that as your benchmark.
Be sure to discuss any benchmark with the manager in advance to ensure it is both appropriate and reasonable; this should help avoid later misunderstandings.
Assets under management
Knowing the trend of assets under management can alert one to potential problems. Many successful hedge fund managers that come to our attention have experienced rapid growth in assets because of strong investment results which, in turn, have attracted more clients.
This raises several questions:
Can the manager that racked up 25% annual gains while assets ranged from $10 million to $20 million do the same when assets exceed $200 million? With a strategy focused on a small niche or narrow segment of the market, the fund might be unable to absorb more dollars without negatively affecting returns or changing its strategy.
Has the fund placed a ceiling on assets it will accept? Failure to do so might indicate a greater desire to gather assets and boost fees than to maximize returns.
A larger firm usually requires additional personnel, upgraded systems and increased management skills. Is the principal now spending more time and energy on business matters than on searching out profitable investments?
Ask prospective fund managers these questions before investing and make sure you are comfortable with the answers.
Confidence in the main guy
The returns of most hedge funds generally are driven by the thinking and efforts of one individual. Even larger funds, which might employ a dozen or more professionals, usually are dominated by a single man or woman.
A high level of confidence in this individual's experience, skill and dedication is absolutely key. It will enable you to endure the inevitable down periods while waiting for those strong upside moves, especially in the more volatile funds.
Knowing a substantial part of the principal's net worth is invested in the fund certainly contributes to building this confidence.
Fees
Someone once said that a hedge fund is simply a private partnership allowing the manager to change outrageous fees for even mediocre performance.
The most widely used arrangement is a base fee (typically 1%) plus a share of profits (usually 20%). This incentive fee helps align the interests of manager and investor.
It also means an investor will pay a fee of 200 basis points on a gross return of 6%. Ouch! Of course, much higher returns are expected and the most important result is the net return to investors, not the fee paid to the manager. However, if you are not comfortable with this type of fee arrangement you might wish to seek out one of the few funds that charge only a flat fee.
Vassar's results
In early 1993 Vassar College invested with a well-known macrofund that makes large, leveraged bets in any asset class where it perceives value - including global stocks and bonds, commodities, and currencies. Of our three holdings, this fund incurs the most risk and therefore has the highest expected return. To date, we have earned a 21% annualized compound return since inception.
Our second hedge fund is best described as an event-driven value fund investing in specific occurrences likely to affect the value of a company. Such events include acquisitions, spinoffs, or the restructuring of a company's operations. A significant portion of its holdings are outside the United States, where the focus is on capital structure arbitrage, sovereign debt and convertible arbitrage strategies.
Our most conservative holding is a fund that employs a truly "hedged" strategy pursued with a low degree of leverage and a large amount of hedging. The main focus is on capital preservation. This firm looks for opportunities in closed-end funds, convertible arbitrage, distressed securities and legally complicated projects where the principal's legal background should be an advantage.
We invested with these last two managers in July 1994. After the first nine months, one fund was essentially flat and the other was down 19%. Despite their rough starts, however, both funds recovered quickly and are now up 11% and 20%, respectively, on an annualized basis since inception.
As stated earlier, Vassar College's goal in adding hedge funds to our portfolio was to increase returns and reduce volatility. To date, we have accomplished the latter, but not the former.
As illustrated in the accompanying graph, our hedge funds have earned a respectable 12.7% since our first investment, and with reasonable volatility (as measured by standard deviation).
Their inclusion has reduced the volatility of the overall portfolio because of the low correlation between our hedge fund returns and the returns of our other holdings. This reduction of portfolio risk through the addition of riskier, but uncorrelated, assets illustrated the magic of diversification.
Although we reduced volatility, we did not increase returns. The problem, if you can call it that, was the spectacular U.S. stock market return during this period - 16% annualized - which led to a portfolio return, excluding hedge funds, of 13.6%. Thus the inclusion of hedge funds actually nicked our results by a few basis points.
But the U.S. stock market will not continue to generate such lofty returns forever.
So when the market crashes, or corrects, or simply reverts to results more consistent with historical experience, we fully expect our hedge fund investments to fulfill both our goals of enhanced endowment returns and reduced risk. Jay A. Yoder is investment analyst at the Vassar College endowment, Poughkeepsie, N.Y.
