Behind the hedge

By BRENT SHEATHER*

If you invest with the help of a financial planner, the chances are that you will have been told about the wonders of hedge funds some time in the past six months.

According to their promoters, hedge funds - or, frequently, "funds of hedge funds" - offer something close to financial nirvana; high returns but low risk.

A big part of hedge funds' appeal is that they provide a ray of hope to investors conditioned to expect a continuation of the high returns that were available in the 80s and 90s, who are loath to accept that we have entered an era of low returns.

A number of local fund managers have been busy this year advocating the particular advantages of hedge investing, not least of which are the high annual fees payable to all involved. Although financial planners and fund managers are not an especially spiritual bunch, they probably regard the timely manifestation of the hedge fund phenomenon as something of a miracle, coming as it does at a time when fees on other products are under pressure and some retail investors are losing faith in last year's favourite, international shares.

Although the concept of hedge funds originated in the United States in 1949, the idea of achieving reasonable and consistent returns on a par with those you can get from shares, but coupled with the low risk you get with bonds, has really caught on locally in the past 12 months or so.

And no wonder, given that the performance of the previous most popular asset class, international shares, has been disappointing, recording two straight years of losses and now facing the prospect of an extraordinary third down year in a row.

While the basic rationale of hedge funds - earning reasonable returns with low risk by exploiting the "mispricing" of various investments - sounds great, there is a niggling worry. That worry is, as has happened before with so many other apparent market anomalies, that as soon as a profitable strategy is widely identified the weight of money thrown at it will cause the trend to disappear and in some cases reverse.

Will strategies that worked with $500 million still work with $5 billion, or will the extra money simply iron out the inefficiencies more quickly and less profitably? Some of the signs aren't good; one technique known as "convertible arbitrage" was the most successful hedge fund strategy last year, attracting some US$7 billion, but so far this year it has been all downhill - the strategy recorded an 0.9 per cent loss over the first four months.

As I'm sure we all know, "convertible arbitrage" involves buying a convertible bond which can be converted into shares, while simultaneously selling short the underlying shares into which it can be converted. If that is not perfectly clear and you are a hedge fund investor, then perhaps you should reflect on Warren Buffet's legendary advice that he never invests in a company which he doesn't understand.

In many ways hedge funds are the antithesis of index fund investing, which eschews active management and the attendant fees and instead focuses on low turnover and buying the index.

Hedge funds tread a very different path; portfolio turnover is high and base fees can be 3 per cent a year plus a share of performance - for both the individual hedge funds and for the overall manager.

With hedge funds, one effectively swaps market risk for manager risk. In the long run the share market inevitably goes up, but with hedge funds you are much more reliant on the manager's skill, or luck.

Research from the University of Reading in Britain is starting to raise more fundamental questions about the commonly held attractions of hedge funds. Associate Professor of Finance Harry Kat looked at the performance of 103 funds of hedge funds between 1994 and last year, and found that the average fund of funds produced a return that was 2.76 per cent lower than would have been obtained by simply making a random selection of hedge funds.

Kat concluded that since the degree of underperformance "more or less equals the fees charged by funds of funds, this strategy suggests that the timing and fund-picking activities of the average fund of funds are not rewarded by a higher return. The average fund of funds appears an expensive way to invest in hedge funds".

In a second paper, "Stocks, Bonds and Hedge Funds : Not a Free Lunch!" Kat notes that while hedge funds do, as their promoters claim, reduce the risk of a portfolio, as measured by how variable its returns are, this is not the end of the story. Although volatility is indeed reduced, including hedge funds in a portfolio increases the chances of an extreme outcome.

Kat also found that hedge funds display something called "negative skewness", which means they have a more than average chance of producing a negative or slightly positive return.

Thirdly, he found that increasing the number of hedge funds in a portfolio increases its correlation with the stockmarket - one of the very things that hedge funds are designed to try to avoid.

In the paper Kat writes: "Our results make it clear that hedge funds do not mix too well with equity. The case for hedge funds is less straightforward than often suggested and requires investors to make a trade-off between profit and loss potential.

"Our results also emphasise that as long as investors do not invest a substantial portion of their wealth in hedge funds, hedge funds will have little or no impact on the overall portfolio characteristics.

"This is an important observation given that most institutional investors currently considering to invest in hedge funds do not appear to be planning to allocate more than 1 to 5 per cent to hedge funds."

There are other clouds on the horizon for hedge funds. The Securities and Exchange Commission in the US last month warned hedge fund investors that it was concerned about the incidence of fraud in the industry, possible conflicts of interest in managing hedge products alongside traditional managed funds, and problems marketing these vehicles directly to investors.

Hedge funds were the flavour of the month in Britain a couple of years back and a number of hedge "funds of funds" listed on the London Stock Exchange. Their performance has in the main been ordinary.

In the past few months many of these funds have ominously begun to trade at discounts to their asset value, having previously traded at large premiums. HedgeFirst, managed by Deutsche Bank's absolute returns team from New York, originally listed at 96p in 2000, and now trades at 89.5p, a 3 per cent discount to net asset value, while AMP's Henderson Absolute Return fund can be purchased for 12 per cent less than the value of its assets.

Deutsche could quite rightly argue that HedgeFirst has been a success, that it has broadly held its value at a time when the stockmarket has fallen sharply.

Fair enough, but if you are worried about stockmarkets falling, it is quite simple to buy government bonds to protect your capital and get a decent income as well.

The real test will be for hedge funds to produce a return for investors when markets eventually turn around.

Hedge funds are purported to have many attractions, but the jury is out on whether investors buying today will make money out of them. What is 100 per cent assured are the base annual fees payable to investment managers and the trailing and initial fees payable to intermediaries selling them.

* Brent Sheather is a Whakatane investment adviser.

* Disclosure : Brent Sheather is a not especially happy investor in two UK listed funds of hedge funds.