Lessons of 2008–2010

Ignore Beta to deliver uncorrelated returns

Originally published in the October 2010 issue

Hedge fund investors have had a fairly rough ride over the last two years. The Madoff scandal, poor investment returns, particularly in 2008, illiquid funds which ‘gate’ investors’ redemption requests, opaque reporting, inappropriate investments, excessive and asymmetric performance fees have all tested even the most loyal advocate of hedge funds. And while the Madoff scandal may have faded into the distant memory of the public at large, there remains a lingering sense that the hedge fund industry has failed to deliver on its own lofty aims.

If you believe what investors tell you, the reason that people use hedge funds is to obtain a return profile which is uncorrelated to the other main asset classes including equities and bonds. This was most recently confirmed in the McKinsey Quick Survey (2009). Presumably, hedge fund investors want uncorrelated returns from hedge funds to dampen volatility arising in their allocations to equity markets and bond markets. So it must have been galling for thoseinvestors to experience average returns of -17% in 2008 at a time when equities were losing a catastrophic -40% as a result of the financial crisis and looming global recession. In other words, 2008 was the one year in the last eight years when hedge funds needed to deliver on their promises and achieve absolute positive returns to offset the equity market crash. But in practice, they failed spectacularly.

How did this come to pass? There are a number of explanations. Managers had focused too heavily on running positive net exposures which had paid off handsomely in the bull market years of 2003 to 2007, but which guaranteed negative returns when equity markets turned south. Portfolios were also biased towards higher beta, smaller cap stocks which became illiquid as the market turned sour, and managers became complacent about finding good hedges to offset risks in the portfolio.

Our own approach to managing the Melchior Selected Trust European Absolute Return Fund has been somewhat different. We have sought to provide a stable return profile irrespective of the market environment by eschewing market risk and focusing on alpha generation in both the long and the short portfolios. This has resulted in positive, single digit returns in each of the last four years. In 2007, our return of 8.0% was considered a little lacklustre by most funds of hedge funds who had become used to a diet of 12%+ returns throughout the bull market years. But in 2008, when our fund returned +6.3%, investors beat a path to our door to learn how we had managed to produce a positive return when so many others had failed.

If only the story had ended there! Sadly for us, 2009 saw a return to bullish equity markets and our constrained approach which had been hailed only a few short months earlier became once again too tame for investors. 2010 is proving to be an altogether more challenging year for hedge funds. Once again, our fund is up 5% while the industry as a whole is in marginally negative performance territory.

I am not advocating that all equity long/short hedge funds should adopt market neutral strategies. That would be nonsense. But I do think investors need to recognise that strategies that rely on beta to generate returns will not deliver the primary purpose of a hedge fund – to deliver uncorrelated returns. In contrast, our own approach of delivering positive returns with limited net exposure to equity markets has ensured that we have achieved what most investors say they want.

I would also suggest that today’s market environment is more conducive to an approach which seeks out alpha rather than beta. That is because the global macro backdrop is so uncertain, creating market volatility and a range-bound market. Funds with a lot of beta tend to underperform during volatile and trendless markets and I suspect that this explains the disappointing performance of so many equity long/short funds this year. In contrast, the search for alpha is presenting plenty of opportunities on both the long and the short portfolio at the moment. Over the year, we have been gradually increasing our gross exposure to take advantage of these opportunities. Our current gross exposure is 125% and we have 38 long stock ideas and 22 short positions.

One of the consequences of a challenging economic back-drop is that the dispersion of performance of companies is very high. Good companies are gaining market share from poor companies and poor companies will fail as and when we return to a normal interest environment. The banking system is a very good example of this dispersion. Some European banks are performing very well as a result of favourable interest rates and the ability to charge high margins. Other banks are limping along, only able to keep alive because of dubious accounting practices and an artificially low interest rate environment.

They key point about the current environment is that there is a lot of alpha to be gained on the short side because so few managers are prepared to risk capital in shorting individual names. Over the first eight months of the year, our short portfolio has generated 10% of alpha on an average gross short exposure of only 40%.

We would also argue that the current volatile environment requires a willingness to trade positions actively to lock in short lived alpha and to respond to macro news flow, M&A activity and the general level of volatility. We use trading to enhance returns and to reduce risk. We also recognise that in benign markets, trading can cost alpha so we are flexible in use of trading.

In spite of the difficult market environment and the poor experience of the last few years, the truth remains that investors are once again committing capital to hedge funds because they hold out the prospect of producing positive returns with lower risk than investing in conventional equity markets. In an era of heightened uncertainty and low interest rates, this ‘promise’ is highly attractive.

The growth of NEWCITS is, in theory, a good thing for the investment community because it widens the investment choice available to most investors. In reality, it will only be a success if hedge fund managers learn from the errors of the recent past.

UCITS is a powerful brand which is recognised not only in Europe but also across Asia and the Middle East. It has been painstakingly nurtured by regulators over many years as an imprimatur for reliability and integrity. The hedge fund industry needs to respect this brand and make sure that they do not bring it into disrepute.

However, UCITS III is not, of itself, a panacea for all of the problems which have been experienced over the last few years. One should not forget that one of the feeder funds for Madoff was itself a UCITS III fund. Under UCITS III, managers will continue to be able to employ strategies which pay only lip service to protecting capital when markets are weak. Managers will also be able to invest in instruments which can become illiquid under certain market conditions leading to the prospect of gating. And, as sure as day follows night, some hedge fund managers will abuse the opportunity presented by UCITS III leading to angry regulators, furious investors and a braying public.

We need to learn from the lessons of the past. We need to provide transparent reporting on portfolios; to avoid taking illiquid positions which cannot be realised to meet investor redemption requests; to ensure that risk levels are appropriate to deliver positive returns in spite of difficult market conditions; and to design fee structures which are fair and balanced.

Leonard Charlton is the Fund Manager of the Melchior European Fund, a long short European equity Fund. He is also a partner of the management firm Dalton Strategic Partnership (DSP).