Secrets of Success: Exploding the no-risk myth of hedge funds

My recent column about hedge funds has produced another small sackload of interesting responses. There seems no doubt that the subject is high on everyone's agenda, if only because every investment banker and intermediary worth their salt is now pushing the idea. I have lost count of the number of acquaintances and professional contacts who are now the proud owners of some kind of hedge fund, even if they are not always quite sure why.

My recent column about hedge funds has produced another small sackload of interesting responses. There seems no doubt that the subject is high on everyone's agenda, if only because every investment banker and intermediary worth their salt is now pushing the idea. I have lost count of the number of acquaintances and professional contacts who are now the proud owners of some kind of hedge fund, even if they are not always quite sure why.

Am I wrong therefore to express reservations about this new phenomenon? I would say not, for two main reasons. One is that it is the job of the media to point out the flaws in new concepts, a thankless but necessary task that can of course be taken to extremes. Pointing out the potential drawbacks in interesting new products does not have to mean that they are a bad idea.

The second reason for sticking to my guns on the subject of hedge funds is that their success in marketing terms tells us more, I fear, about the attitudes of investors than it does about the product itself. The big question is whether what people are buying hedge funds for is actually something that hedge funds can deliver on any larger scale.

For what really are hedge funds about? I see no reason to change my earlier view that the investment space hedge funds in their current incarnation are trying to fill is that formerly occupied by with-profits policies and bonds. This may seem a surprising analogy, but the parallels are strikingly close. What both with-profits and hedge funds set out to offer is the prospect of steady absolute returns - that is, investments that produce better returns than cash on a regular basis, free of the fluctuations that you get if you invest directly in the stock market, or in a mixed fund that holds equities, bonds and cash.

In other words they are both products that hold out the prospect of increasing your wealth in real terms without the anxiety of watching the value of your investments go up and down in the meantime.

The fact that the way with-profits and hedge funds set out to achieve the same objective could not be more different does not alter this central point. The traditional life company solution was to hold a balanced portfolio of stocks, bonds and other assets and smooth the returns by requiring investors to hold their funds for 10-25 years; cross-subsidising those who stayed the course at the expense of those who dropped out; and wrapping up the results of the fund in such a cloud of non-transparency that few investors had any idea how well their fund was doing.

The new breed of hedge funds attacks the target of steady absolute returns from a different end of the investment spectrum. Instead of holding assets for the long term, their preferred method is to buy and sell assets for very short periods, taking advantage of small market anomalies and magnifying the returns through a variety of forms of gearing. In this context the kind of fund that George Soros used to run so successfully - a "macro fund" that takes big bets on movements in markets of all kinds, with highly volatile results - is the exception, not the rule.

Like with-profits, the hedge fund business has traditionally preferred to operate behind a veil of secrecy. Until recently a typical hedge fund was limited to 99 wealthy investors who were happy to sign an agreement that limited their ability to get out of the fund except at lengthy pre-ordained intervals. They also had to be people who accepted the risk of their money not being policed by regulators and were happy not to ask too many questions about exactly how the funds made money.

There are obvious difficulties with translating this into a product that can safely be sold to retail investors. Of course, there are good reasons why any fund offering absolute real returns year in year out prefers to operate behind a veil. One is that the more you tell people what the current value of their investment is, the more liable they are to take fright and desert the ship at inconvenient moments.

The second reason is the awkward notion that there is no way of achieving constant real returns without some degree of risk. Professor Harry Kat, a former derivatives expert who now runs a research centre into hedge funds at City University, has sent me a fascinating paper that outlines in detail the reasons why hedge funds are more risky than people realise. This is despite the fact that the conventional measures investment firms use to measure risk-adjusted returns appear to show that hedge funds are achieving the impossible, namely producing real returns without apparent extra risk.

I don't have space to rehearse all the arguments here, but statistics experts will probably appreciate the point that performance data are subject to survivorship bias on an even greater scale than conventional funds; and the more insidious fact that hedge fund returns are not normally distributed, which means that conventional risk-return analysis systematically understates their riskiness.

What is true is that the cream of the talent in the fund management business is moving into hedge funds, for the simple reason that, if they make a success of it, they will earn fabulous multiples of what they can make by managing a boring unit trust. A few "fund of fund" hedge funds will soon be offered in packages to private investors and some, at least, will do an excellent job - but like with-profits, many more will, I suspect, disappoint.

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

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