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

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

News
Howard Marks who has been diagnosed with inoperable cancer aged 69
people
Arts and Entertainment
Benedict Cumberbatch has spoken about the lack of opportunities for black British actors in the UK
film
Voices
Winston Churchill, then prime minister, outside No 10 in June 1943
voicesA C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
News
Rowan Atkinson at the wheel of his McLaren F1 GTR sports car
people
PROMOTED VIDEO
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Tax Assistant

    Negotiable: Recruitment Genius: A Tax Assistant is required to join a leading ...

    Recruitment Genius: Outbound Sales Executive - OTE £25,000

    £16000 - £25000 per annum: Recruitment Genius: This is an exciting opportunity...

    Ashdown Group: Java Developer / J2EE Developer - Watford - £45,000 - £47,000

    £45000 - £47000 per annum + bonus + benefits: Ashdown Group: Java Developer / ...

    Ashdown Group: Marketing Product Manager - (Financial Services) - SW London

    £35000 - £38000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

    Day In a Page

    Iraq invasion 2003: The bloody warnings six wise men gave to Tony Blair as he prepared to launch poorly planned campaign

    What the six wise men told Tony Blair

    Months before the invasion of Iraq in 2003, experts sought to warn the PM about his plans. Here, four of them recall that day
    25 years of The Independent on Sunday: The stories, the writers and the changes over the last quarter of a century

    25 years of The Independent on Sunday

    The stories, the writers and the changes over the last quarter of a century
    Homeless Veterans appeal: 'Really caring is a dangerous emotion in this kind of work'

    Homeless Veterans appeal

    As head of The Soldiers' Charity, Martin Rutledge has to temper compassion with realism. He tells Chris Green how his Army career prepared him
    Wu-Tang Clan and The Sexual Objects offer fans a chance to own the only copies of their latest albums

    Smash hit go under the hammer

    It's nice to pick up a new record once in a while, but the purchasers of two latest releases can go a step further - by buying the only copy
    Geeks who rocked the world: Documentary looks back at origins of the computer-games industry

    The geeks who rocked the world

    A new documentary looks back at origins of the computer-games industry
    Belle & Sebastian interview: Stuart Murdoch reveals how the band is taking a new direction

    Belle & Sebastian is taking a new direction

    Twenty years ago, Belle & Sebastian was a fey indie band from Glasgow. It still is – except today, as prime mover Stuart Murdoch admits, it has a global cult following, from Hollywood to South Korea
    America: Land of the free, home of the political dynasty

    America: Land of the free, home of the political dynasty

    These days in the US things are pretty much stuck where they are, both in politics and society at large, says Rupert Cornwell
    A graphic history of US civil rights – in comic book form

    A graphic history of US civil rights – in comic book form

    A veteran of the Fifties campaigns is inspiring a new generation of activists
    Winston Churchill: the enigma of a British hero

    Winston Churchill: the enigma of a British hero

    A C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
    Growing mussels: Precious freshwater shellfish are thriving in a unique green project

    Growing mussels

    Precious freshwater shellfish are thriving in a unique green project
    Diana Krall: The jazz singer on being friends with Elton John, outer space and skiing in Dubai

    Diana Krall interview

    The jazz singer on being friends with Elton John, outer space and skiing in Dubai
    Pinstriped for action: A glimpse of what the very rich man will be wearing this winter

    Pinstriped for action

    A glimpse of what the very rich man will be wearing this winter
    Russell T Davies & Ben Cook: 'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'

    Russell T Davies & Ben Cook: How we met

    'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'
    Bill Granger recipes: Our chef serves up his favourite Japanese dishes

    Bill Granger's Japanese recipes

    Stock up on mirin, soy and miso and you have the makings of everyday Japanese cuisine
    Michael Calvin: How we need more Eric Cantonas to knock some sense into us

    Michael Calvin's Last Word

    How we need more Eric Cantonas to knock some sense into us