Hedge funds–where has the Alpha gone…?

Hedge Funds Kiss Their Alpha Goodbye: what a surprise!  I have never been enamoured of hedge funds as a separate asset class per se or the arguments used by many to justify their blanket inclusion in portfolios.  I have always felt that many of the above average type hedge fund returns could be accessed by deep contrarian plays which most investors are unlikely to be able to stomach, but also that many of the hedge fund plays themselves, once you accounted for the management costs and the leverage, were hardly superior to straightforward investing.    Many of the returns available during the 1990s and the first two years of the noughties, were there by virtue of market itself: note the value plays of the late 1990s and early 2000s which set up many hedge funds for above average returns.  Since then, the return differentials have declined.  And note, the chart in the linked article provides a rolling 60 month period, meaning that the slow and steady decline shown exists only by virtue of trailing returns.    Hedge funds and niche valuation plays should only be used by those with the valuation models and resources needed to assess the opportunities and risks, but lack the manpower and resources to actually manage.   Please note my 2006 report on Hedge Funds within Private Client Portfolios and under noted excerpt from the report.

July 2006 – Hedge Funds & Their Place in the Private Client Portfolio



Conclusion

Hedge funds are a far more complex area than many would like to believe. This is not because they are complex beasts, they are, but because they appear to answer the prayers of many an investor and, they appear to offer something for nothing while having an argument that appears to back up their claims.

They appear to offer lower volatility (?)

In reality, the actual risk of a hedge fund is higher than the volatility would suggest and, they introduce a whole host of other potentially more dangerous risks to the portfolio. The focus on standard deviation is unhealthy since it detracts from valuation risks which are a far more important source of risk. A properly constructed portfolio should have the diversification needed to reduce overall volatility and the structure to protect the client from risks far more significant in their impact than standard deviation.

As an investment style they appear to offer superior return (?)

Hedge funds in their heyday, the late 1980s to early 1990s may well have done, according to the performance figures, but over the last 10 to 12 years, no, as an investment style, they definitely have not. While the earlier average returns may have been biased upwards, perhaps significantly so, the latest performance figures give serious cause for concern over the rationale for the vast majority of hedge fund investment. You would have been better serviced by a conventional portfolio where short term risk was managed by low risk asset allocation and where long term return was managed by a simple value biased index. Hedge fund type attributes are not the preserve of the hedge fund industry. They have been available at the margin for a very long period of time.

They promise to complement a portfolio’s allocation to stocks and bonds (?)

If you do not know the allocation of an investment and you do not know the risk position of an investment, then you cannot value or allocate or manage an allocation to the investment. Quite how an asset class whose market neutral hub appears to perfom like a bond but is higher risk in nature and under performs a value biased equity index, whose risk may explode during a significant risk event, that is illiquid, exposed to high attrition rates and fraud can be referenced by a bland, innocuous statement of universal application is absurd.

But the attributes of a hedge fund are very much needed for the efficient and structured management of risk and return over time, especially in the presence of financial needs. The good news is you do not need a hedge fund to do this. The bad news is that you do need access to higher level asset management expertise and portfolio construction expertise that is generally unavailable to most investors, and that is the rub. Many investors are left between a rock and a hard place.

This is not to say that hedge funds do not have a place. If you are wealthy enough to be able to afford the risks of the funds that can deliver the returns and, you have access to the expertise that can select and manage your hedge fund investments and that also has the sense to keep these outside of your core portfolio, then hedge fund investment may have a role. But they are definitely not for all and sundry and they are definitely not the domesticated retail friendly animals we are led to believe.

In truth the entire portfolio should be hedged to some degree or other and at any one point in time, depending on market and economic risks, the management of excess risk and return at the margin will account for between 5% and 20% of portfolio allocation. But this activity should be managed within a central portfolio structure that values, allocates and manages all its components in accordance with the long and the short demands of the portfolio.

The only time an allocation to a hedge fund can be considered at all is where the allocation and management of the hedge fund is aligned with the valuation, allocation and management framework of the portfolio itself.

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