Money: Taking a peek behind the investment hedge

Hedge funds - unwarranted risk or financial strategy of the future? BRENT SHEATHER looks at the phenomenon

Equity long/short, event driven, global macro.

No, they're not the names of characters from the children's TV series Pokemon. They are strategies employed by "hedge funds," an investment medium growing in leaps and bounds in the United States and Europe.

Before long these words may be as common in business publications as "insider trading" and "poor corporate governance" are these days.

For many, though, the jury is still out on hedge funds.

I am as cynical as the next person about claims of high returns and low risk, but over the past 10 years some very sensible investors have put serious money - $US450 billion or so ($998 billion) into this type of alternative investment medium.

If hedge funds make sense for some of the world's biggest pension funds, such as the Californian Public Employees Retirement System, then maybe they make some sense for more sophisticated private investors too, if only as a small portion of their total portfolio.

Alternative asset investment, as practised by hedge funds, has had a lot of bad press in the past few years, with the meltdown of Long Term Capital Management and the retirement of George Soros and Julian Robertson making headlines.

Much of their risky reputation is undeserved. Indeed, even the term "alternative asset" is misleading.

The reality is that the assets commonly traded by hedge funds are normally equity and debt listed on the world's most highly liquid and regulated exchanges.

It is not the investments that are alternative, but the investment style.

Traditional investment management involves buying an asset and hoping it goes up in price, whereas hedge fund managers mostly employ "absolute return strategies," aiming to achieve positive returns regardless of the market's direction.

For example, a hedge fund manager with an aversion to shares can resort to cash, insure his or her portfolio using derivatives, and, of course, go short (selling shares he or she doesn't own, hoping their price will fall). More conventional managers, on the other hand, must keep the vast majority of their portfolios invested.

Another common misconception is that hedge funds borrow heavily. However, LTCM - which borrowed $40 for every $1 investors put in - was an aberration. Since its near collapse no banker would dare finance that sort of position again.

Historically, there have been two competing theories of investment.

The first is the traditional efficient markets theory, which says share prices already reflect all market information and prices can only temporarily be "high" or "low." It is therefore impossible for investment managers to make excess profits over the long term without undue risk. This theory is the basis for the traditional "buy and hold" approach, in which returns come mainly from the market's overall direction.

The second theory argues that greater inefficiencies occur, and therefore opportunities can arise that enable investors to exploit mispriced securities without excessive risk. This is the principal argument behind hedge fund investing. Hedge fund managers aim to achieve steady absolute returns with low risk, rather than performance relative to a certain index.

So, 50 years after US-based Australian Alfred Jones invented the hedge fund concept in 1949, why are such funds, hitherto the exclusive domain of the very wealthy, becoming popular with mainstream institutional and retail investors?

The main factor, as always, is the pursuit of returns.

Pundits predict a return to sharemarkets producing 7 to 8 per cent a year in the long run, with increasing volatility, making the traditional approach less attractive.

The long bull market has not been good news for hedge managers, but in the soggy market of the new millennium hedge fund managers are beginning to smile.

Although perceived to be higher risk, many hedge funds have less volatility than the traditional equity portfolio. More importantly, the correlation with share portfolios tends to be low, and lower still for bonds. As a result investors can gain important diversification benefits from adding hedge funds to their portfolios.

Accordingly, Deutsche Bank's optimum portfolio models imply a 6 to 16 per cent weighting in hedge funds.

Another key factor behind their popularity is that fund managers who think outside the square find their creativity increasingly constrained by the impact of benchmarking - measuring returns against an index.

At the other end of the spectrum, many supposedly active managers are under pressure from index funds offering lower costs and volatility.

Performance fees also comprise a much larger portion of the typical hedge fund manager's compensation, which means they have the same goal as their investors, allowing successful managers to earn more.

For this reason, hedge fund proponents point to the trend for the best long equity fund managers to eventually start their own hedge funds.

So far so good, but do hedge funds actually deliver? Don't risk and return go hand in hand?

Professor Narayen Naik, of the London Business School, has studied the performance of many hedge funds and gives the industry a qualified thumb's up.

Professor Naik's study finds that hedge fund strategies outperformed their benchmark by more than 6 per cent a year from 1994 to 1998.

But he notes that good managers generally don't stay good for long, which means investors must manage their hedge fund portfolios.

As this is outside the scope of most private investors, the best strategy is to use a fund of hedge funds, where a manager picks the funds for you. Unfortunately, this introduces yet another level of fees.

"It is now well known that the traditional active strategies such as investing in mutual funds, on average, underperform passive investment strategies," says Professor Naik. "The few mutual fund managers who successfully beat the passive strategies tend to move into the arena of alternative investments and start their own hedge funds."

It is also important to remember that although typical hedge funds no longer employ high-risk global macro strategies (a la George Soros speculating on the British pound), "market neutral" investing is not "risk-free" investing.

Market neutral investing is achieved by a fund manager buying shares which he or she expects will rise and selling short those shares which are expected to fall.

While the manager has neutralised the portfolio's exposure to the overall movement of the market, there is still a risk - what if the stocks that were sold short in fact rise in value, while those which were bought fall? And many of the strategies employed by hedge funds are useful only on a relatively limited scale, which is why many better performing hedge funds are closed to new investors.

But while accepting the alternative investment approach is one thing, actually buying a diversified portfolio of hedge funds is more difficult. For the retail investor with a spare $10,000 or so, hedge funds are a bit thin on the ground.

Furthermore, such funds are often registered in tax havens like Nassau, Guernsey or the Isle of Man, meaning that if you own more than $50,000 of that sort of fund, any capital gains are taxable.

However, all is not lost. The London Financial Times recently reported that reputable British institutions are organising a fund of hedge funds for retail and institutional investors timed for the first quarter of 2001.

In the meantime, the list below includes three instruments which are easily accessible and represent different approaches to alternative investment:

* Alternative Investment Strategies - a London-listed fund of hedge funds.

* Tower-GAM Multi-trading - a fund of funds unit trust, trading bonds, currencies and commodities.

* Schroder Ventures - a London-listed venture capital fund.


* Brent Sheather is a Whakatane stockbroker.

* Disclosure: Sheather owns shares in Alternative Investment Strategies and Schroder Ventures.