Jonathan Davis: Why it pays investors not to hide behind the hedge funds

My advice is: don't be tempted until or unless you have really done your homework

Hedge funds are beginning to make inroads into the broader retail and institutional markets, having for many years been much seen as a tool for only the wealthy and sophisticated investor. There has been a big push in the past few months to broaden the investor base of hedge funds, with big name investment banks (including the likes of HSBC, Deutsche Bank and Merrill Lynch) launching funds of this type.

Despite the spectacular collapse of Long Term Capital Management 30 months ago, which briefly threatened to tarnish the hedge fund concept, the more recent story has been one of increasing market push and investor acceptance of these traditionally secretive and rarely understood investment vehicles. There are good reasons why in the current investment climate hedge funds might seem attractive, since in principle they offer a superior risk-return profile to conventional funds when stock markets are falling.

Yet not all the recent hedge fund launches have gone quite as well as their promoters clearly hoped. Some recent launches have attracted reasonable amounts of money, but they have still fallen short of the providers' more optimistic targets. This is despite the sharp setback in global equity markets in the first quarter of the year and worries about potential future returns on offer from conventional "long-only" funds. (At Warren Buffett's annual meeting this weekend he again advised investors to revise down their expectations of future stock market returns from 15 per cent per annum to more like half that amount.)

One problem with hedge funds, as the investment author Peter Temple points out in his excellent new book on the subject, The Courtesans of Capitalism (John Wiley Ltd), is that the blanket term covers a wide variety of different types of fund. There is no point in considering a hedge fund unless you are fully aware of what you are buying. What makes the task doubly difficult is that a majority of hedge funds are, strictly speaking, not hedge funds.

The original hedge fund concept was invented in the United States in the late Forties by a one-time journalist and lecturer called Alfred Winslow Jones. Given the universal agreement among investment professionals, that forecasting future stock market movements is nearly impossible in the short term, his great insight was to realise that a skilful stock-picker can eliminate so-called market risk almost completely by running carefully matched "long" and "short" positions at the same time. That is to say, by buying a mixture of "undervalued" shares and selling short equal amounts of "overpriced" shares, the manager of a hedge fund can ­ if he or she is smart enough ­ generate positive returns for investors independently of movements in the stock market.

Aside from the strategy of going both long and short of shares at the same time, two other important features of the original hedge fund concept were that the fund employed leverage (ie, borrowings) to jack up its returns and that the fund manager was rewarded with incentive fees. But as Mr Temple points out this original concept has been extended to incorporate a wide range of funds that employ some, but by no means all, of these techniques. Nearly all hedge funds retain the idea of performance fees, and most use leverage, but only a minority are actually hedged, in part or at all, in the original sense that Alfred Winslow Jones intended, that is to say they are structured so as to eliminate market risk.

Today's hedge funds also cover a wide variety of different styles, techniques and strategies. One simple way to grasp the wide spectrum of funds operating under the hedge fund umbrella is to look at the risk and return data provided by CSFB/Tremont at www.hedgeindex.com. The table summarises some data from this source, and shows how funds in different segments performed recently. Risk is summarised by three measures. These are drawdown (roughly speaking, the largest peak-to-trough decline in value the fund has experienced), the standard deviation of returns (the higher the figure, the more volatile the fund's performance) and a measure of risk-adjusted returns known as the Sharpe ratio (the higher the figure, the better risk/reward profile).

To further amplify what this means, the chart shows the different pattern of returns from two distinct styles of hedge funds, market-neutral funds, which broadly adopt the classical hedged style of Jones the pioneer, and long/short equity funds, which typically take more aggressive and riskier leveraged bets on which direction the market is heading.

Interesting lessons can be drawn from these figures. One is that the market-neutral approach has produced the best risk-adjusted returns over time, as evidenced by the smallest drawdown, the least volatility and the highest Sharpe ratio. Other styles are much more volatile, and one suspects might leave Mr Jones aghast, were he still alive. Note how the "global macro" style, essentially that adopted by the big global speculators, such as George Soros, is a very high risk way of investing. The second thing to note is that the return figures probably overstate the actual returns investors have enjoyed, since many hedge funds carry unquoted investments which may not be worth as much as they are reported to be. There is also the statistical hazard of survivorship bias (the funds that have gone belly-up are, by definition, excluded from the latest figures).

But the returns are quoted net of performance fees, which means the absolute returns achieved by hedge funds before the managers take their cut is higher than the figures shown here. The ability to make huge amounts of money very quickly from incentive fees is the reason why some of the sharpest investment managers switch to running hedge funds, though it is debatable how far this influences the way they run the money in the funds.

The other notable thing about the figures is that the net returns to investors are nothing like as high as you might have been led to believe. Of course, these figures are averages and they disguise some spectacular differences in individual fund performance. But, in aggregate, hedge funds have not delivered returns higher than the stock market overall, and they look less impressive still after you allow for the leverage and risk involved. Given this painful reality, it is almost certain that many of those now being drawn to invest in hedge funds may be doing so for the wrong reasons, or with an inadequate understanding of what they are getting into. It is, at least, open to question whether some of the newly rich, whose money is so avidly courted by banks, and others may not now be vulnerable to the kind of "status" investing that led so many so disastrously into Lloyd's of London 20 years ago.

What is undeniably true is that hedge funds have outperformed stock markets in general strongly in the past two years. This year to date, the CSFB Tremont index shows that only one of the seven main hedge fund styles it monitors has produced negative returns at a time when nearly every global stock market is down by at least 8 to 15 per cent. That record will undoubtedly help to sustain the marketing effort behind hedge funds, and demonstrates that the concept has sound foundations. But they need to be set against the high costs, illiquidity and hidden risks involved in many cases.

My advice is: don't be tempted until or unless you have really done your homework. Peter Temple's book is a good starting point. Read it before you open that next tempting new prospectus from the glitzy investment bank.

davisbiz@aol.com