Will hedge funds catch on with pension fund sponsors more rapidly than did the emerging markets, where less than 4% of total pension fund assets have been allocated?
A hedge fund can be described as a private investment partnership in which the general partner has made a substantial personal investment and the fund can take both long and short positions, use leverage and invest in many markets. But some funds use no leverage, and many of them have quite narrow investment criteria.
A good reason for pension fund sponsors to look toward hedge funds is that recent market volatility continues to place a major strain on equity and bond prices.
Increasing interest rates, the rise in commodity prices, high p/e ratios or a weak dollar suggest a bear market may be close at hand.
Several other indicators point to a market correction: the dollar has dropped below 100 yen for the first time since World War II; oil prices have climbed above $20 a barrel, up 50% from its lows of the year; the Commodities Research Bureau index is at its highest level since October 1990; and the long bond finished the first half of the year at 7.61%, a bit below its peak of 7.64% in early May, but far above the 6.34% where it wound up 1993.
Traditional long-only managers could be sitting on a time bomb if such a negative scenario came to pass. Historically, long-only managers have used food, tobacco and pharmaceutical stocks to adopt a defensive posture but certainly, the tobacco and pharmaceutical sectors cannot be relied upon to perform this function in the current political environment, and "brand names" in the food sector are losing market share to private label competitors.
Many in the industry feel the potential exists for a corrective secular bear market of 20% or more. Hedge funds offer far better protection in mediocre to down markets than traditional money managers, although they do not perform as well in raging bull markets, largely because of the costs incurred in hedging. This is clearly seen in Figure 1, which shows hedge fund and mutual fund returns between 1987 and 1993.
Based on the foregoing, it is easy to see why some tax-exempt institutional investors view hedge funds as a viable asset class. These institutions have dealt with the misconceptions surrounding hedge funds, namely:
Hedge funds are too risky an investment;
All hedge funds use similar strategies;
All hedge funds are losing money in 1994;.
Hedge funds can manipulate market movements;
There is no oversight of hedge funds; and
Hedge fund managers are paid too much.
Hedge funds are too risky. Many believe hedge funds use exotic derivatives that can be illiquid during times of crisis. While some like David Askin used structured derivatives, the most commonly used derivatives are exchange-listed futures and options employed to hedge the downside risk of a particular investment strategy. These derivatives have far greater liquidity and do not pose the risks of the exotics.
In fact, our data indicate that those hedge fund managers that shorted Standard & Poor's futures to protect their stock-picking long strategies did well during the first quarter.
Funds use similar strategies. Republic Hedge Fund Select has a database of more than 600 hedge funds, up from only 100 in 1987, and we classify them by 11 investment styles. George Soros, for example, adopts what is called a macro style. The other styles we categorize are growth, risk arbitrage, value, short only, distressed securities, opportunistic, international, convertible arbitrage, emerging markets and market neutral.
Performance for January through June 1994 for these individual styles are: growth, -2.51%; risk arbitrage, 5.73%; value, -0.13%; short only, 32.07%; macro, -15.69%; distressed securities, 3.77%; opportunistic, 1.90%; international, 0.51%; convertible arbitrage, -7.29%; emerging markets, -3.31%; and market neutral, -1.08%.
All funds lost money this year. This is not true. Returns indicate five styles are actually in positive territory this year. Short only did poorly in January but then rallied.
Hedge funds manipulate markets. Hedge funds have been accused of moving markets, foreign exchange markets in particular. But as George Soros pointed out in his testimony before Congress, global turnover of the nine largest foreign exchange markets is approximately $946 billion per day. His funds might engage in transactions with a total value of $500 million a day, which would represent only about 1/1,800th of the daily global trading volume.
If Soros Fund Management constitutes approximately 15% of the money invested in hedge funds and if other hedge funds trade currencies to the same extent as Soros does (which they do not), then all hedge funds in the aggregate control at most 1/180th (or 0.005) of the daily global trading volume in the foreign exchange markets.
Hedge funds lack oversight. Hedge funds may be regulated by the Securities and Exchange Commission, the Commodities Futures Trading Commission, or both. In fact, our database indicates more than 85 hedge fund managers who are registered investment advisers. Investment managers who exercise discretion over equities with an aggregate value of more than $100 million must file that information with the SEC.
All hedge fund managers are subject to anti-fraud provisions in the 1940 Investment Advisors Act that prohibit any "fraudulent, deceptive or manipulative act, practice or course of action." The SEC has proposed a rule that would require all large traders, including hedge fund managers, to provide more information through their respective broker dealers. They would do this by filing a "large trader" report with the SEC.
In January, the investment companies committee of the American Institute of Certified Public Accountants recommended that hedge funds disclose a condensed schedule of their investments, and the Financial Accounting Standards Board seems likely to approve this recommendation.
U.S.-based hedge fund managers who trade futures on a non-incidental basis in their portfolio are required to register as commodity pool operators with the CTFC, although waivers may be possible in some circumstances.
Managers are paid too much. Much has been made of the fees paid to hedge fund managers. Since most compensation is performance fee-related, many sophisticated investors feel that managers are worth the money. In addition, most managers have their own money invested, so they have a strong incentive to generate high returns and manage their risks.
Historically, net of fees, investors still earn more from hedge funds than traditional money management styles. An investment in hedge funds certainly seems to offer a win/win combination. It is also important to note that their compensation structure has attracted some of the best talent away from Wall Street and traditional money management careers.
A viable asset class
A number of fund sponsors like to see that any new asset class they invest in has little correlation with an existing class. We analyzed our database to see what correlation existed between the various investment styles and the S&P 500. In addition we used this database along with some of the better known indexes to establish an optimal asset mix along the efficient frontier.
There was little correlation between any of our investment styles and the S&P 500. The highest level of correlation, at 76%, was between the growth style and the S&P 500; only three other styles had a level of correlation with the S&P 500 above 50%.
There was also little correlation among the various investment styles; the highest level of correlation, at 77%, was between the growth and risk arbitrage styles.
This low correlation leads to several favorable results. Because there is a lack of correlation among the different styles, a portfolio of hedge fund styles actually carries less risk than the S&P 500.
By combining a portfolio of hedge funds with the Standard & Poor's 500 Stock Index, the risk level is reduced while the annualized return increases as the proportion of hedge funds relative to the S&P increases. When the S&P 500 is combined with a more risky individual style, the return at first increases and the risk level decreases as small amounts of the macro style are combined with the S&P 500; after the combination exceeds 40% macro style, it is necessary to assume greater levels of risk to achieve higher returns.
We constructed the efficient frontier using both Modern Portfolio Theory and Post-Modern Portfolio Theory. The theories employ different measures of risk, namely the conventional standard deviation measure under MPT and the downside risk as measured by target semi-deviation under PMPT.
Downside risk is an extension of the concept of semi-variance originally stated by Harry Markowitz, and it makes a clear distinction between downside and upside volatility. Only volatility below the target results in risk; returns above the target rate are not interpreted as risky. Downside risk also takes into account that management styles have return distributions skewed either positively or negatively.
The efficient frontiers under the two theories are shown in Figures 2 and 3. They have been drawn up using quarterly returns from July 1989 to May 1994 (the April/May 1994 period was assumed to be a complete quarter).
In Figure 2, the top line signifies the efficient frontier under MPT using a combination of hedge fund styles, the Lehman Brothers Aggregate Bond Index, the S&P 500 and Treasury bills. The bottom line shows the efficient frontier using just a combination of the bond index, the S&P 500 and T-bills. Figure 3 shows similar frontiers under PMPT.
In both cases, the efficient frontiers move favorably upwards by combining hedge funds with more traditional investment vehicles so that a fund sponsor can construct a portfolio offering greater return for a given level of risk.
We thought it would be interesting to see what asset classes made up the portfolios - under both MPT and PMPT - that would provide similar levels of risk to a portfolio made up of only the S&P 500, Lehman Brothers Aggregate Index and T-bills ("the compared portfolio").
The compared portfolio had an expected return of 10% in both cases.
Under MPT, it had a standard deviation of 8.4 and under PMPT a downside risk of 12.9. Under MPT, to achieve a similar risk level as the compared portfolio using different styles of hedge funds, the dominant style would be distressed, at 45% of the portfolio, followed by macro at 25% and international at 17%; no other style comprises more than 6% of the portfolio.
Under PMPT, the makeup of the portfolio is different, with emerging markets comprising 67% of the portfolio; macro, 32%; and international, 1%.
Uniqueness of hedge funds
The uniqueness of hedge funds comes from their ability to re-group and change direction, reducing net long positions or even going net short relatively quickly.
This ability is often diminished when a portfolio gets too large and managers cannot nimbly move in and out of positions, something readily seen in a recent review of mutual funds.
At present, hedge funds represent only a fraction of the managed money industry. In general, we estimate more than 70% of hedge fund investors are wealthy individuals who have received outstanding returns from hedge fund investments.
Hedge funds, or incentive-based asset managers, are going to be a permanent presence on the investment scene.
One day it may be deemed irresponsible not to have a portion of a pension fund's assets in defensive investments.
By including hedge funds in a portfolio of asset types, it is possible to move the efficient frontier into a more favorable position and provide the sponsor, foundation or endowment with a higher degree of confidence that the actuarial return assumptions will be met.
One way of doing this is to opt for a fund of funds.
Funds of funds are an efficient way to enter this asset class and achieve diversification with 10 to 20 managers without having to evaluate over 30 managers.
Probably more than with any other asset class, it is essential that the pension fund sponsor use a consultant to become thoroughly educated about the manager or fund of funds manager, his or her investment style and the methodology used in arriving at the investment decision.
Once a manager is hired, the consultant can provide a monthly monitor that will enable the sponsor to see peer measurement from an independent source.
E. Lee Hennessee is senior vice president at Hedge Fund Select of Republic New York Securities, New York.
Also contributing to this story were Gregory Joseph, Hobson Barnes, Melanie Marshack and Charles Gradante.