|
|
 |
|
| Feature |
Hedging Our Bets
John Ferry
11/01/2004
|
If we naively apply this model to a portfolio that includes hedge funds, the
allocation to the funds could be quite large: Hedge funds offer good
diversification; they are typically uncorrelated with other asset classes; and
historical data indicates their returns are relatively high while their risks
are relatively low. Yet before we rush to embrace this seemingly remarkable
investment class, experts counsel that there is more to hedge funds than meets
the eye. “We don’t want to put our clients’ portfolios 60 or 70 percent into
hedge funds,” says Douglas Allison, managing director of Beacon Pointe Advisors
in Newport Beach, Calif. “It may appear to make sense, but I’m just not willing
to risk my client’s money, because hedge funds have a number of inherent risks
that do not show up in the data.”
The quality and completeness of the data
is the weak link with hedge funds. Modern portfolio theory works well when we
are dealing with traditional asset classes, such as equities or government
bonds, which come with abundant historical performance data. The hedge fund
market, however, is not nearly as transparent or well established. Only in
recent years has real data on returns become available, and even then some
question the reliability of this data. “The data is simply looking at the
risk-weighted return, and even if you assume that that is correct, it ignores
other aspects,” says Andrew Popper, a group chief investment officer with SG
Hambros in London.
Several weaknesses plague hedge fund data. First, not all
managers submit information to hedge fund databases. Managers of underperforming
funds may not want to advertise the fact that they are not keeping up with their
peers. Others, whose funds are successful but are perhaps closed to new
investors, might also be shy of publicity because they simply do not need to
advertise.
Meanwhile, the quality of the pricing information offered by the
funds is often suspect. It is very difficult to effectively value many types of
hedge fund positions, because the investments are illiquid, meaning they are not
actively traded, and do not therefore have a market price. In these cases,
managers or third-party appraisers must, essentially, guess at the value of the
investments, based on comparable assets or complex financial models. (Click image to enlarge)
Popper
notes that other factors, unique to hedge funds, put them beyond the purview of
modern portfolio theory. Perhaps the most important is the fact that their
performance is often not amenable to the type of statistical analysis that can
be applied to other types of investments. The returns of hedge funds, unlike
those of stocks or bonds, do not form the classical normal distribution (or bell
curve) when plotted on a graph. “[Modern portfolio theory] only makes sense as
long as the results of the investments are normally distributed, but there is a
case to be made that the tails of the distribution for hedge funds are not
normal,” Popper says. This means that the probability of an extreme event—say
the collapse of an emerging market economy—severely disrupting a hedge fund is
higher than the models suggest. Furthermore, optimization models used to decide
on an allocation do not take account of the relative lack of liquidity of hedge
fund investments—investors typically face a lock-up period of one to two years,
whereas an investment in stock can usually be unwound at a moment’s
notice.
Finally, there are several idiosyncratic problems that stem from the
fact that hedge funds are typically managed by a small number of individuals and
feature low levels of oversight and transparency. Hedge fund managers could
change their investment strategy without informing investors, a fact that many
overlook as they perform due diligence. “Typical due-diligence approaches focus
on the investment capabilities of the fund itself—what its performance track
record has been and how consistent that is,” says Ed Hawthorne, managing
principal of New York-based hedge fund advisory company Capco. “But these
approaches don’t go very far toward understanding the operations and controls of
the enterprise and their ability to withstand shocks—there could be an
operational error or an opportunity to misrepresent the fund.”
Optimize and Allocate
Because of these various hedge fund risks and data
biases, our wealth advisors will typically err on the side of caution, and with
good reason. When determining how much to invest, an advisor’s first step is to
assess our risk and return objectives, as well as our spending needs and
investment time horizon. “You have two kinds of high-net-worth hedge fund
investors,” says Joelle Weiss, New York president of the Swiss private wealth
management group Compagnie Bancaire Geneve (CBG) Investment Advisors. “You have
the guy who is entrepreneurial and is always looking to be very aggressive. He
uses hedge funds to really look after the 20 or 30 percent a year returns. These
guys are more momentum driven; they are always looking to make the big buck.
Then you have the high-net-worth guy who is enticed to hedge funds for the
opposite reason: He can get a very steady return with very low volatility and
actually still make Libor [a benchmark interest rate] plus 7 or 8
percent.”
|
|
|
|
|
|
|
; function voidFunc() { } voidFunc();)
