AIMA (Alternative Investment Management Association) published a roadmap to hedge funds in November 2008. This is the first collaborative educational guide between institutional investors and the hedge fund industry, i.e., the first practical guide to hedge fund investing for investors, written by investors. The Roadmap, which is freely available on AIMA’s website, was commissioned by AIMA’s Investor Steering Committee (composed of a number of the world’s leading investors) in association with UBS Global Asset Management, CalPERS, and CAIAA (Chartered Alternative Investment Analyst Association).
The Roadmap has been launched at a point in the industry’s development where the quantity of commentary on hedge funds is not necessarily supported by a good quality of knowledge. The Roadmap will assist the growing number of institutional investors making allocations to hedge funds and directly addresses the current misconceptions surrounding hedge funds and their practices, including short selling.
The Roadmap also offers guidance on creating and managing hedge fund portfolios and gives an in-depth view of hedge fund strategies in investment, valuation, leverage, liquidity and risk management. The Roadmap is freely available to all and is targeted particularly at trustees and fiduciaries, though will be useful to all others with an interest in the hedge fund industry. The following picks up some aspects of the content from the Roadmap starting with a definition for hedge funds.
“A hedge fund constitutes an investment program whereby the managers or partners seek absolute returns by exploiting investment opportunities while trying to protect principal from potential financial loss. The first hedge fund was indeed a hedged fund. The hedge funds/alternative investment moniker is a description of what an investment fund is not rather than what it is. The universe of alternative investments is just that – the universe.”
Benjamin Graham, arguably one of the founding fathers of investment management as a profession, distinguished investment from speculation in both his main works, ‘Security Analysis’ and ‘The Intelligent Investor’, by writing: ‘An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.’
It is interesting, then, to note that in the investment management industry today, “safety of principal” is, in fact, a rare thing. Surprisingly, the emphasis on “safety of principal” is found not in mainstream traditional asset management but in the “alternative fringe” of the industry, i.e. among absolute return managers such as hedge funds and funds of hedge funds.
Absolute return managers seek to exploit an edge of some sort to make profits while at the same time attempting to limit the loss of principal. Protecting principal is an essential part of their mandates. This is materially different from the traditional asset management industry, where the focus is on outperforming or replicating a market benchmark. Safety of principal is not part of a standard relative return mandate.
It is ironic then that hedge funds have been vigorously criticised (by nearly everyone except for their long-term investors) as being dangerously non-transparent, unregulated and excessively levered. The irony is that banks have, until quite recently, not been criticised, are tightly regulated and therefore perceived as transparent, use much more leverage than hedge funds and, as a sector, recently lost around 60% of their market value in a period where the hedge fund sector lost around 9% and at the time of writing the credit crunch is not over.
The favourable relative performance of hedge funds is worth highlighting as it is often brushed aside and is in stark contrast to the heavy artillery the industry regularly finds itself under: a hypothetical investment in the S&P 500 Total Return Index of a US$100 at the beginning of this decade stood at US$76.6 by October 2008. A hypothetical investment of US$100 in the HFRI Fund Weighted Hedge Fund Index stood at US$161.8. We think this to be a big difference.
The pursuit of absolute returns is much older than the idea of beating a benchmark. Constructing portfolios with low compound annual returns, high volatility and high probability of large drawdowns is easy. Constructing portfolios with high compound annual returns, low volatility and low probability of large drawdowns is not. Losses kill the rate at which capital compounds. Defining risk as the attempt to avoid losses is materially different from trying to avoid underperforming a benchmark. The paradigm of relative returns might soon be perceived as a short blip or ideological error in the evolution of investment management.
Hedge funds are active investment managers. Active investment management is dependent on the willingness to embrace change and, more importantly, to capitalise on it. Adaptability is the key to longevity. In active risk management, it is important to apply a skill that carries a reward in the market place within an opportunity set where the risk/reward trade-off is skewed in favour of the risk-taker. The reward from skill is not constant. Profitable ideas, approaches and techniques get copied and markets become immune to the applicability of the skill: that is, markets become more efficient. Skill needs to be dynamic and adaptive: that is, it needs to evolve to remain of value.
Hedge funds do not hedge all risks. If all risks were hedged, the returns would be hedged too. Hedge funds take risk where they expect to get paid for bearing risk while hedging risks that carry no premium.
The investment process of a hedge fund investor is dynamic and can be classified into two selection processes (manager selection and portfolio construction) and two monitoring processes (manager review and risk management). Initial and ongoing assessment and due diligence of the hedge fund managers is probably the single most important aspect of the investment process for all hedge fund investors.
Portfolio construction and managing the risk of the hedge fund portfolio are also mission-critical in the hugely heterogeneous and dynamic hedge fund industry. Manager evaluation and monitoring has become more difficult, despite increases in transparency and information flow, and it has become more labour-intensive. Investors with vast resources for research are likely to continue to have an edge over investors with little or no research capabilities.
One of the central drivers of alternative investments in this decade is the realisation by an increasing number of investors that the source of returns from various alternative asset classes and hedge fund strategies is not identical. While there are varying complicating matters such as valuation and liquidity issues as well as non-linear payouts, the bottom line is that the source of return from various ‘alternatives’ differs fundamentally.
ABOUT THE AUTHOR
Alexander Ineichen is Managing Director and Senior Investment Officer for Alternative Investment Solutions, a business within the Alternative and Quantitative Investments platform, itself a part of UBS Global Asset Management. His main responsibilities include asset allocation, risk management and other research initiatives.