Offering greater flexibility than traditional vehicles, hedge funds are tailored to individual needs, thereby improving overall returns and decreasing risk
This week's Conjecture focuses on hedge funds.
Taking part in the debate were Jamie Murray, head of business development and distribution at HSBC Alternative Assets, David Yarrow, a founding director at Clareville Capital, and Catherine Vaughn, vice president and head of European business development at Highbridge Capital Management, which in 2004 entered into a strategic partnership with JPMorgan Chase.
What do you believe are the broad benefits of hedge funds?
Catherine Vaughn (CV): Hedge funds are most widely recognised for the fact they may provide an uncorrelated source of returns to the rest of a portfolio and, depending on the strategy, a source of steady returns. With alternative investments, and hedge funds in particular, the idea of including them in a portfolio is to improve the overall return and potentially decrease overall risk.
Hedge funds have very different strategies and some are more dependent on the returns of the market than others. Depending on what type of strategy the hedge fund is engaged in there will be a different sort of risk profile added to a portfolio when hedge funds are invested in. Generally speaking the structure of a hedge fund allows the investment manager much greater flexibility and therefore allows that manager many different ways to express their views.
Jamie Murray (JM): An interesting phrase I heard once was that traditional fund managers are investing with one hand tied behind their back compared to hedge funds. That might be a slightly controversial thing to say but there is a lot more flexibility to what a hedge fund manager can do.
Hedge fund managers can build a whole range of different types of portfolios, from extremely conservative vehicles where the underlying volatility might be half of say something like the JPMorgan Global Government Bond index, to vehicles that are a little bit more punchy but still very good at controlling underlying volatility. As a fund of hedge funds provider, that is one of the things we focus on a great deal with our clients. We are focused more than anything on tailoring solutions to meet specific client requirements.
Generally, most fund of hedge funds are probably targeting mid-level returns of cash plus about 5%. One way to look at them then is as a diversifier sitting between bonds and equities in a portfolio. Typically, globally-diversified funds of hedge funds have generated returns that have been significantly higher than bonds over time but with about the same kind of volatility.
David Yarrow (DY): As a manager of a long/short equity fund, it is important to remember that we are in the fourth year of a bull market and in those conditions it is difficult to compete with people that are 100% net invested in cash.
We must remember two things. First, in 2001 and 2002 an awful lot of money was lost around the world by endowments, by pension funds and by direct investment in equities. I do not think I was necessarily brighter than people running long-only money in those years but we were in a position to be able to exploit the burst of the TMT bubble. Equally, when markets are benign, we are able to employ gearing and concentration in our portfolios, which gives us flexibility.
I think it is fascinating that the industry has grown so much at a time when other investment classes are making an awful lot of money. Luckily the financial world knows we should not be judged on 12-month performance and what matters more than anything else is your ability to preserve capital when things are tough and be flexible when things are benign. I think hedge funds can do both those things.
The hedge fund industry does not seem to be that interested in courting the retail market. Is this attitude likely to change?
DY: We like British retail investors because they tend to be uncorrelated to one another and tend to do things that are contingent on their own personal circumstances. That said, I think one has to be very wary of courting a particular area of the world. Around seven or eight years ago you could find yourself with 80% of your money coming from a single street in Geneva. In cases like that, when one investor moves they all tend to do so.
So retail investors do provide a degree of robustness to your client base. Also, a lot of retail investors are bright and wealthy people themselves and the more conduits of information you have the better.
Does the UK hedge fund business suffer from the lack of onshore regulation of hedge funds?
JM: It is certainly a major source of the negativity we see. It must cause compliance departments and financial advisory groups to think quite hard before they approve these products for sale to retail-type clients.
We need to see a kind of democratisation of the ability to invest in hedge funds. It seems a shame that institutions and high net worth individuals investing offshore tend to be the main ones accessing these vehicles when these are great products in terms of providing diversification.
I am hopeful that in the coming months we should see the FSA starting to regulate at the very least funds of hedge funds.
How does the US market compare in terms of retail investment activity?
CV: Most hedge funds at present do not have the infrastructure or the knowledge of the retail asset management world to engage in supporting the retail market fully. Hedge funds have enjoyed success by offering limited partnership vehicles and that is why just the most sophisticated and wealthiest institutions and investors have been investing in them. They are the ones that are able to access these limited partnership vehicles.
In some cases we have seen hedge funds partner with asset managers to take investment techniques that have been successful in traditional hedge funds and make them available in different structures.
However, generally speaking hedge funds are trying to preserve the edge they believe they are afforded because there is so much flexibility allowed in the hedge fund vehicle. In markets where there is additional regulatory oversight, hedge fund managers generally are not as anxious to engage in them because it may impede their ability to use the same investment techniques that have been so successful for them in the past.