Allocating to hedge funds for the ordinary individual and for most financial advisers/advisors is as easy as passing through the eye of the needle
In the passive active debate there is a duality, two universes living side by side. And by this I mean we have those who say that active management is a zero sum game and worse when fees and transaction costs are taken into consideration. On the other hand we have those who say that active management is not a zero sum game and that value can be added even after fees and transaction costs are taken into account. Interestingly academics have taken both sides of the debate.
While you would find it hard to find an academic that supported mutual fund active performance, there are those that support active management from hedge funds (alpha generation). I refer in particular to a working paper, The ABC’s of Hedge Funds: Alphas Betas, and Costs By Roger G. Ibbotson, Ph.D. and Peng Chen, Ph.D., CFA
We analyze the performance of a universe of about 8,400 hedge funds from the TASS database from January 1995 through December 2009. Our results indicate that both survivorship and backfill biases are potentially serious problems. Adjusting for these biases brings the net return from 14.26% to 7.63% for the equally weighted sample. Over the entire period, this return is slightly lower than the S&P 500 return of 8.04%, but includes a statistically significant positive alpha. We estimate a pre-fee return of 11.42%, which we split into a fee (3.78%), an alpha (3.01%), and a beta return (4.62%)
…..our analysis concentrates on separating the hedge fund returns using only the traditional stock, bond, and cash beta exposures that are easily assessable for investors without hedge funds…
Nevertheless, since hedge funds are the primary way to gain exposure to these non-traditional betas, these non traditional betas should be viewed as part of the value-added that hedge funds provide compared to traditional long-only managers.
What is the above actually saying? it is saying that within the broad allocation and flow of money assets as they exchange for securities and other assets, there are numerous different component flows that move at different rates, in different directions and in different cycles. Money flows impact valuations, risks and returns, and by being able to isolate and allocate to these flows hedge funds have the potential to earn a return over and above a blanket market allocation.
What the paper does not say, and it points this out, is whether the hedge funds are beating a similarly weighted passive allocation to these flows. And, I think is a good point, and it is a point I have made myself: this is that you need your own valuation, allocation and management framework if you are to move outside the market weighting to a specific asset class. At a portfolio level you would need to determine which is the most efficient vehicle to access the market segment/valuation differential, and if there is no passive vehicle that does the same you need to allocate the most competitive active vehicle.
But allocating to hedge funds for the ordinary individual and for most financial advisers/advisors is as easy as passing through the eye of the needle. You should only allocate, in my opinion, to hedge funds if you have a valuation, allocation and management model, a framework that can value and manage the allocation to these segmental flows in the market place. And most do not.
Buying any vehicle on past performance, without your a valuation allocation and management framework to house your allocation decision is exposing the portfolio to unknown uncertainty of return and uncertainty of risk.
There is a role for active management, but it is not 100% of the portfolio. And why? Well, while I disagree with the existence of a general equilibrium (a pre condition for MPT), it is the difference between the current out of equilibrium market allocation and the target general equilibrium allocation to which active management needs to be allocating to. And while going the other side of the market trade is also a risk management strategy as well as a return strategy, leveraging the differential as a multiple of the valuation differential (which many funds do) is a risk to that return – a risk I might point out that increases as the observed valuation differential diminishes.
Therefore, a second definable rule of hedge fund investing (the first is the requirement for a VAM framework) is that allocations beyond the valuation differential need to be carefully calibrated to risk aversion and liability profile, and the smaller the valuation differential the greater the risk.
In other words, if the financial services industry is going to be able to recommend hedge funds to ordinary investors it needs a well supported valuation, allocation and management framework and a careful calibration of allocation to risk profiles, liability profiles and valuation differentials. In other words the vast majority of advisors and investors should steer clear of hedge funds and stick to low cost, passive, broad market allocation vehicles.
Mutual funds remain compromised between the duality because they mostly provide market allocation for an active cost while lacking a differential valuation, allocation and management framework to effectively manage the active.
And one final word: conflicts of interest will ultimately prevent hedge funds from properly managing the differential, because as the differential closes (this is what happens when the trade gets crowded), and the risks of exploiting the differential increase, hedge funds should withdraw money from the strategy and return it to investors. I doubt this actually happens, since most assets are returned or withdrawn after the decline has started.
This is also a conflict of interest for mutual funds: that is the supposition that they can actively and effectively manage the active through all points in time.