As the biggest hedge fund insider trading case comes to a close, we are reminded of the risks of investing in the asset class. Ever since generating losses in 2008, the reputation of these 'absolute return' vehicles has been damaged. The Madoff scandal which topped off the year did not help. Nevertheless, whilst clarity in the markets remains illusive and with a wider range of tools to exploit opportunities, are they a form of investment to be feared or favored?
A Tainted Asset Class
Disappointed and disillusioned, many investors are reluctant to revisit the asset class run by managers once hailed as the new "masters of the universe". Sold on the promise of generating positive performance in any market environment or at the very least preserving capital in times of stress, losses generated in 2008 came as a shock. With the Madoff scandal came the realization that even funds that did consistently generate steady returns were not immune to trouble. There is even an aptly named "Hedge Fund Implode-o-Meter" website tracking the number of major funds which have "imploded" since late 2006 (out of interest the number at last look stands at 117, although this includes all funds suffering any form of "permanent adverse change", not just total shutdown).
But Not All Are Created Equal
Not all hedge funds should be tarred with the same brush and although grouped within the same category, they can differ tremendously. From the investment vehicles in which they invest to the stringency of their risk management, not all are created equal. The Hedge Fund Association summed the situation up succinctly with the assertion that "investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds."
Losses Were Often Greater Elsewhere
Putting aside the often misleading 'absolute return' banner, the average hedge fund was better able to preserve capital through the market downturn than a regular 'long-only' mutual fund. Whilst the MSCI World Index fell 42% in 2008, the Credit/Suisse Tremont Hedge Fund Index fell 19%, More impressive still were the 21% of funds which posted positive returns for the year (the majority of which were up double digits). Crucially, over a more appropriate investment horizon of 3 years, according to figures by EDHEC Business School, "The majority of hedge funds delivered better returns than the S&P 500 index". Hedge Funds have shown themselves able of generating highly attractive returns.
The Tide Has Changed
Investors have demanded more. In 2008 they 'spoke with their feet' and the hedge fund industry suffered $782bn of redemptions. The Hedge Funds had to listen. What was requested, according to a report by Scorpio Partnership, was "transparency, simplicity and liquidity". Likewise, the Hedge Fund Scandals were a wake up call to investors and much more focus is being placed on operational due diligence, to avoid investing in any future hedge fund failures.
Investment Conclusion: Well-Positioned to Exploit Opportunities
With the risk of future macro shocks clouding the horizon (read: Japan, Middle East, EU Sovereign Debt), the direction of the markets is somewhat hard to predict. Therefore investing with flexible managers able to react to the quickly changing environment and nimble enough to exploit opportunities when they present themselves seems an attractive move. Not all investments are created equal, but some are more equal than others.
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The term "hedge" fund is too broad. There are some funds that are quite vanilla and actually much less risky than investing in the stock market. Consider "long-short" strategies, where every dollar invested is also shorted against another stock, thereby hedging the multiple risk. If I were to buy Ford and short GM in equal amounts for example, I would break even, absent transaction costs, if both stocks declined by 40%, then I would break even. If I owned a plain vanilla fund, I lose 40%.
On other hand, some funds use too much leverage and try to engineer returns by exploiting small mispricings in various (often illiquid) asset classes (usually betting on the revision to the mean). Think Long Term Capital Management. Run from these.
Yes and some funds are involved in currencies and in global macro trends. These guys are having a field day borrowing the dollar and investing in higher-yielding currencies. Thanks Ben!
As in all things, do your homework. But you can't paint all of these funds with the same brush.
Over 3000 hedge funds made money in 2008. Even the "average" hedge fund beat the S&P by 20% that year. Hedge funds are not an asset class. Reputation and institutional due diligence has never been better. Madoff did not run or even claim to run a hedge fund.
Your retirement plan needs them. 100%. Safer than stocks and now safer than bonds. Much cheaper than anything John Bogle pushes
Of any nation, how many people really (not trickle-down "economics") profit from hedge funds? How many suffer (in the way that they involuntary have to contribute to the gains)? Now, if a tool - and hedge funds are no more a tool than many other pieces of science and/or math - is not considered overall useful for a society, than it needs to be banned. If it can be used in productive as well as in harmful ways, it needs to be restricted so harm (at best) is avoided or sanctioned. But most of all (this especially applies to hedge funds), the minute they show that they hold sway over sovereign, parliamentary decisions, they should be considered unconstitutional and dealt with accordingly. Because at the end, the fund managers and the investors are persons who are under national jurisdiction and who have to fall in line, period.
IMO, the whole question is false: Today, the ones who have enough money to actually make their living from such investments or the fund managers are emotionally detached from the societies to which they should belong. As emotionally detached as they are, society should treat them: whithout fear and without favor, just their net worth to the whole.
I find two other questions much more disturbing: On the one hand, the sheer size. If a single or a handful of HFs acting in concert are able to even game a G20 economy, I think they are out of proportion.
The second point is: It seems to me some have a handful of private or institutional investors which bring in the backbone of capital and then a lot of money from unaware, small sources (our pensions etc.) is brought in. So, if a HF goes bust, someone who didn't even know where is money was used might end up loosing it. And even if you are aware: Only the big capital contributors have a say in the strategy, not the many, many small investors. It seems to me, that should be seperated; means, HFs who collect a lot of "small money" should be disallowed to accept private or institutional investments above a certain ceiling.