The case for hedge funds 2009

Redemptions from hedge funds peaked at the end of December 2008, as primarily private investors asked for their money back. By contrast, institutional investors, such as pension and endowment funds, generally retained their positions and, in some cases, took advantage by gaining access to previously closed managers. More recently, China’s $200 billion sovereign wealth fund, China Investment Corp., has announced its intention to increase exposure to hedge funds over the coming years.

Short selling and leverage – myth and reality

Several studies refute the claim that hedge funds caused the steep falls in stock markets which accompanied the financial crisis. Nor do they show that the bans on short selling – where funds borrow stocks to sell now, in the hope of buying them back later at a lower price – had the intended effects, notably of protecting the financial sector. Last October, Hector Sants, chief executive of the UK’s Financial Services Authority (FSA), said that, "contrary to the expectations of some commentators…hedge funds were not the catalyst or driver of last summer’s market events."Meanwhile, in the US, the former chairman of the Securities and Exchange Commission (SEC), Christopher Cox, acknowledged last December that the biggest mistake of his tenure was agreeing to the ban on the short selling of stocks in financial companies. As for leverage, FSA figures show that the average hedge fund borrowed $1.92 for every dollar of equity invested in October 2007. That number had fallen to $1.45 by April 2008, $1.15 by October 2008 and to around $1 by April 2009. Not only did leverage in the industry start to decline before Lehman’s collapse; it has always been far lower than for many investment banks or, in fact, UK home-buyers.

So what may the new world of hedge funds look like?

A recent study by Scorpio Partnership has suggested that the key emerging themes for asset allocation and portfolio construction are transparency, simplicity and liquidity. That would undoubtedly have consequences for the hedge fund industry. Transparency may mean different things for different people though. Institutional investors and asset allocators have always asked for more detail in the past and are likely to raise the bar further, but they have the resources to analyse this information. Unfortunately, most private investors don’t, so they may have to accept some lack of transparency, relying on their investment advisor to do the necessary analysis.

As for simplicity, the very concept of hedge fund investing appears to be at odds with what private investors are looking for. By definition, hedge fund managers apply complex investment strategies in specific markets and asset classes. Finally, investors should see liquidity in a portfolio context. If they want a high level of liquidity across all their investments, hedge fund products may not be the best route to take. That said, liquidity is a function of a manager’s underlying investments and generally varies by hedge fund strategy, from daily to yearly. Managers who want to restrict investors’ liquidity will have to demonstrate more than ever that the restrictions are justified by the nature of their strategy and the returns.

The regulatory environment for hedge funds will change as well. There is evidence that the FSA and the SEC will each take a measured approach, asking for more transparency or tightening criteria for regulatory registration but letting the hedge fund industry operate within those parameters. It is not yet clear how much hedge funds operating in the EU or selling to EU residents will be affected by tighter regulation from Brussels.

What does this mean for investors?

The events last year were a reminder of several principles of investing:

• If you want to exceed cash returns, you have to take risks and sacrifice liquidity.
• In order to generate returns, hedge funds have always taken risks. That’s why investors should diversify across various funds, strategies and asset classes, and that’s why hedge fund products should form only part of a diversified portfolio.
• Liquidity comes at a price. In the case of listed hedge funds, for example, the price investors pay for liquidity has come in the form of substantial discounts to net asset value.
• Investing – including absolute return investing – is not a short-term concept. No professional hedge fund manager should guarantee positive returns in any one year or even month.

Hedge funds are no holy grail for investors. They require long-term commitment and some degree of risk appetite. But they do share with many investors a wish not to follow a benchmark. So, if managers don’t like the look of the market, they can choose to hold cash. Most of our Equity Hedged managers have been doing that and have preserved capital during the early part of 2009. It is this absolute return approach which enabled hedge funds to mitigate the losses sustained during this crisis and to generate positive returns over longer time horizons (see chart). Hedge funds also offer unique access to niche asset classes such as convertible bonds.

Of course, only time will tell whether the hedge fund industry has seen the worst of this crisis, but there are definitely signs of recovery: returns have stabilised, redemption pressure has abated, institutional investors appear to remain committed to these kinds of investments, and the regulatory approach has become more measured. Don’t count the hedge fund industry out yet!

This article expresses Coutts views as of 5th August 2009.

Uwe Ketelsen, Product Strategy and Development Manager.