Wednesday, March 25, 2009
Hedge funds outperform equity benchmarks on a risk-adjusted basis over ALL time horizons. So far in 2009 most hedge funds that I follow are up while unhedged long only has lost over -10% after a disastrous -40% in 2008. Despite being negative last year, even the index of "all" hedge funds delivered 22% of alpha when compared to long only. But absolute returns are the raison d'etre and why anyone would invest in an AVERAGE hedge fund is incomprehensible to me. It's almost as weird as wasting time and money in an "average" stock. With the right evaluation techniques investors can do a LOT better than "alternative beta".
The Pareto principle rules - 80% of alpha is generated by 20% of managers. There is nothing unexpected about recent "aggregate" numbers and good hedge funds continue to deliver EXACTLY what they promised - uncorrelated absolute returns with capital preservation. Portable alpha redistributes from the unskilled to the skilled. 2 out of 3 of hedge funds shut down in 1970 but the following 40 years saw LOTS of industry expansion AND investor acceptance. No business sector grows in a straight line. Good hedge funds HAVE generated the performance that investors require. Not long from now hedge funds will be FRONT AND CENTER in most portfolios. Did the dot.com implosion slow internet growth? For every Netscape, Etoys and Excite along comes a Google, Twitter and Facebook. Creative destruction drives the hedge fund world too.
I suppose stock markets might eventually get back to where they once were. But even if I get hold of a Financial Times from March 2029 showing the Dow, Nikkei, Dax and FTSE all above 100,000, I STILL won't be betting on long only. Under that scenario I KNOW good hedge funds will return more. And if those benchmarks turn out to be LOWER than today, hedge funds will also have outperformed. The demand for GENUINE sources of absolute return is growing but that unrequitted love affair with stocks has jilted many investors. The long only crowd say risk appetite will return but I'll be staying in the safe haven of hedge funds. Skilled long/short security selection and many different strategies offers a smoother ride whatever the future holds. UNHEDGED funds are not for investors like me so I'll avoid the stock market rollercoaster.
Why should bull markets or bear markets affect the capital growth of a TRULY diversified portfolio? Traditional asset allocation has not met the expectations of many investors. The ONLY hedge for a long is a short. As the last decade has shown, if you own lots of stocks, bonds, real estate, private equity and commodities you are NOT sufficiently diversified. Long only assets are correlated particularly in bear markets. A robust portfolio requires substantial allocations to those skill-based strategies that do NOT depend on rising asset classes or a strong economy for success.
Anyone who regularly meets with hedge fund managers and bothers to look CLOSELY at the data quickly concludes that the more cautious an investor's risk tolerance, the more of their portfolio they need in quality hedge funds. I have the notion that the sole purpose of fund managers is to make money for their clients over USEFUL time frames without deep drawdowns. 50% losses are FAR beyond the acceptable level of risk with +100% needed to just get back to breakeven. I simply examine the FACTS and the empirical evidence clearly PROVES the lower risk and higher performance of good hedge funds. Diversification with lots of completely different strategies is of course critical to optimal portfolio construction for the long term.
Not investing in any stock because of Bernie Ebbers would be dumb so why are some uninformed "experts" arguing for avoiding quality absolute return strategies because of some fraudulent stockbroker called Bernie Madoff? That would be almost as stupid as those avoiding honest funds of funds that actually do due diligence because of Bernie Cornfeld. One of the best hedge fund managers in history was Bernie Baruch; if only governments had access to his sagacity today as President Roosevelt did during the 1930s depression. It is not helpful to rely solely on economists to "advise" on the economy.
The stigma of high sigma renders unhedged equity funds unsuitable for those who seek reliable performance at low volatility. The blandiloquence of the index fund afficionados with their "cheap" fees but expensive losses has not helped investors this decade. The fact that equities could underperform bonds over long periods refutes such theories. Stocks constitute an opportunity set of securities to buy and short sell. There is no mythic equity risk premium. History is bunk but investment skill does exist. Beta isn't dead, it was never alive BUT alpha is thriving, as usual. For alpha generation, you need a better data set and better ways of extracting information from that data set. Hedge funds are NOT an asset class; they are skilled strategies applied within and between asset classes.
Redemptions? Sure some cash is being transitioned and manager mixes should always be upgraded. You have to redeem from the underperformers before you can reinvest in the better hedge funds. It is also great news for the new money that will be coming in. The removal of the beta repackagers, that pretended to be "hedge funds" but got blown away by the market meltdown, improves the quality of the industry. Isn't that how capitalism is supposed to work? Doesn't the cull of the bottom quartiles IMPROVE the strength of the industry? Some are redeeming for liquidity reasons due to bigger losses in public and private equity. When money is taken from excellent hedge funds for ATM purposes, it creates more space for long term investors' money.
Investors care about performance, not asset gathering accolades, so why is reduced AUM a "bad" thing given that is it likely to lead to INCREASED performance? Smaller size hedge funds and a better manager universe means HIGHER returns and less crowded trades. There are MORE arbitrages, dislocations, anomalies and mispricings around for those with the ability to find them than ever before. As we saw with previous "death of hedge fund" predictions in the 1980s and 1990s, shaking out the losers is good for the absolute return industry and even better for investors.
Public scrutiny of "secretive", "unregulated" hedge funds is fine as long as it also brings public availability. Rarely have the FORWARD-LOOKING alpha opportunities been brighter and who can afford to take the damaging risk of beta again? The turmoil has eliminated funds with poor risk management processes while the departure of hot money has expanded the capacity available for investors that understand the long term diversification VALUE of good hedge funds. The shakeout is POSITIVE for those seeking alpha.
The more unsophisticated money that departs simply creates more room for people that appreciate the VALUE, SAFETY and RISK REDUCTION properties of good hedge funds. Alpha-centric portfolios requires skilled security selection and risk management. Since skill is rare and performance dispersion wide, strategy analysis, manager evaluation and portfolio optimization adds more alpha. No-one claims investing in hedge funds is easy. Choosing index funds is easier but "passive" returns have been very damaging.
Aggregate returns when the hedge fund industry was smaller in size were larger. Robust strategies have capacity and implementation constraints so a lower AUM is likely POSITIVE for performance. Changes in the financial market? Sure but the best managers adapt to ANY conditions. Variant perception and negative sentiment creates opportunities for those who do the hard work and analytical heavy lifting to identify the value through the hysteria and non-expert commentary. Following the crowd often results in wealth destruction. As last year showed, the zero sum alpha game means lots of managers to be wrong. The animal spirit nature of the markets inevitably results in some alpha winners but more beta losers. If "everyone" is making money then something is wrong.
Time is worth more than money so I shall not be waiting around for stock markets to recover when so many talented managers are at or near their high water marks NOW. With better solutions available, why endure the deadly drawdowns, vicious volatility and ridiculous risk of the stock market? Life is short and liabilities grow so who has decades available to await the alleged upward drift of the index? Reliable long term returns require attention to short term risk. In the worst bear markets there are always rising stocks and there are plenty of short sell candidates during bull markets. Long only index based investing guarantees too much money flows to bad stocks. Tracking a benchmark means the same HIGH risk as the benchmark is taken. Equity capital should flow to good companies; not ones that "have to be bought" because they are big and someone else actively decided to include them in their "passive" index.
By replacing market risk with quality manager risk, investors get reliable growth with capital preservation irrespective of underlying market direction. If they diversify, do their homework and are advised properly, investors DO get compensated for taking good hedge fund manager risk but they have NOT been paid for taking stock market risk for far TOO long. Individual investors need absolute returns in reasonable time frames. Whether you have $1,000 or $1 trillion to put to work, a substantial allocation to skill-based, risk managed absolute return strategies is ESSENTIAL. Investors need performance whatever the economic situation. In fact they need it even more in tough economic times.
The very rare hedge fund that loses -100% receives saturated global media coverage but there have not been many articles on the hedge funds that MADE +100% in 2008. Some believe that by holding on long enough, traditional portfolios will be fine. Economists rarely let the FACTS get in the way of their assumptions. The long only crowd claim that by staying in for the "long haul", UNHEDGED funds are all your portfolio needs. Conversely anyone who looks closely at PROPER hedge funds quickly sees their overwhelming superiority and safety. The critics know very little about hedge funds and have usually never invested in one themselves but still think their opinions are valid. The world changed; the mantra of buy and hold was over last century.
No place to hide? Actually there have been plenty of places to hide during the market turbulence. For managed futures CTAs, options traders and short biased strategies, 2008 was a superb year. Cash isn't king when it yields zero. Traditional asset allocation simply hasn't worked very well; skill based security selection with strategies that DIVERSIFY are what work. If an investor wants RELIABLE growth at limited risk in ANY scenario, a well constructed portfolio of quality hedge funds running DIFFERENT strategies is the way to achieve it.
Stay the course? But what course is the economy on in the long term? How should one invest given that we do not know market conditions in the future? Why the stoic indifference to portfolio pain when proven antidotes are available? The answer is with the absolute return managers that have the talent and incentives to make money irrespective of market direction. Modern portfolio theory doesn't need a tweak; it needs an extreme makeover. Any manager that loses -50% TWICE in a decade does not seem to merit a place in a risk averse portfolio. Bull market? It's always a bull market for investing in good hedge funds.
Posted by Bud Fox at 7:52 AM