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Hedging Our Bets
John Ferry
11/01/2004
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The advisor’s next job is to run the optimization model while
taking the various data biases and hedge fund risks into account. According to
Popper, this is a subjective process, and a knowledgeable advisor generally
makes a qualitative judgment and lowers the allocation to hedge funds
accordingly. “If the model tells you that the hedge fund allocation should be 30
or 35 percent, as happens many times, in our view you have to temper that with
the other judgments,” he says. “In our case we believe that around 15 percent is
the right allocation.” Popper adds, however, that in bespoke cases SG Hambros
will recommend a much higher allocation for clients with large sums to invest
and the right risk appetite.
According to Beacon Pointe’s Allison, his firm
will typically recommend about a 10 to 15 percent allocation, with a maximum of
around 25 percent, depending on the client’s goals and objectives. A typical CBG
client, Weiss says, has about 10 percent invested in hedge funds. “But if you
ask our chief investment officer in Geneva, he wants to bring the percentage to
around 30 percent for a typical client portfolio. He doesn’t see the global
markets on an up-line, and he sees a lot of interim volatility, so he sees hedge
funds and alternatives as a safer place to be.”
Allison reports that Beacon
Pointe ran a constrained optimization model—with the market-neutral hedge fund
investment constrained to 15 percent—and found that by adding the hedge fund
element, the client’s portfolio risk is reduced while there is a potential
increase in return. This seems to confirm that a constrained allocation to hedge
funds improves the risk-and-return characteristics of a portfolio.
Options Abound
Since their inception, hedge funds have possessed a
well-deserved reputation for exclusivity. According to Hedges, during the 1980s
it was difficult for many investors to gain access to hedge funds. “It was an
entirely cocktail-circuit-driven method of marketing—it was antimarketing
marketing.” Recognizing an unmet need, Hedges and his family established LJH
Global Investments in Naples, Fla., to provide hedge fund access to other
wealthy investors. This sort of hedge-centric entrepreneurship, combined with a
proliferation of new funds, has enabled the private investor to gain exposure to
this once-exclusive asset class.
Yet experts caution that direct investment
in hedge funds is only advisable for those of us with considerable investable
assets. “Unless you have a minimum of at least $10 million, conservatively, to
invest, then it doesn’t make sense to allocate to hedge funds directly,” says
Raj Mehta, founding partner and managing director of advisory firm Persistent
Edge Management in San Francisco. Following Mehta’s advice, with a 10 percent
direct-investment hedge fund allocation worth $10 million, we should ideally
have investable assets of roughly $100 million.
To get the benefits of hedge
funds then, most advisors recommend that only the ultra-wealthy or family
offices opt for direct investment, with funds of funds or an index investment
being a more appropriate vehicle for others. “You need a critical mass of money
to build a diversified portfolio of at least 15 to 20 managers, as there is a
significant amount of strategy, style, region and manager risk,” Mehta says.
“And you also need enough time, energy and resources to manage
that.”
 | | GRAPH 2 illustrates the historical volatility of the CSFB/Tremont index compared
with that of the S&P 500. To date, the equity index has consistently
recorded more volatility than its hedge fund counterpart. (Click image to enlarge) |
Analysis of the historical returns figures of the CSFB/Tremont Hedge Fund
Index since its inception at the end of 1993 shows mixed performance. As Graph 1
indicates, the index did not start to outperform the S&P 500 equity index
until the technology bubble of the late 1990s truly burst. Since then, it
has consistently outperformed its equity counterpart. But looking at the
returns figures tells only half the story. The volatility, or risk, that an
investor has to take to make those returns is equally important. (See Graph
2 above.) And it is here that the hedge fund index shows its real value. The S&P
500 has been consistently riskier than the CSFB/Tremont index.
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