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EVERYTHING YOU NEED TO
KNOW ABOUTbut INVESTMENT
were afraid to ask!
5: WHAT ARE HEDGE FUNDS?
Does the phrase ‘hedge funds’ send
a shiver down your spine? Do you
glaze over while your consultant
happily talks to you about ‘shortselling’ or ‘merger arbitrage’.
Worry no more, as we explain what
hedge funds – the heroes of asset
management – actually do
L
esson number one: don’t panic! They may seem
baffling, expensive and horribly dangerous, but
hedge funds need not give you nightmares. Like
anything in investing, when broken down they are not as
incomprehensible or exotic as they seem.
These days pension funds in the UK and worldwide
are increasingly pondering about investing in hedge
funds, and with consultants more often mentioning them
than not, trustees need to know the basics.
But there are a lot of myths and legends surrounding
hedge funds – so forget everything you know, or think
you know, and read on!
Firstly, hedge funds are many and varied, but what
they all have in common is that they can ‘bet’ on the
price of an investment falling – whether it is a share or a
bond. Conventional investment managers can only buy
investments and hope their price rises.
Hedge funds are also typically unregulated and can
borrow money to increase the value of their investments.
However, there the definitions end because hedge
funds can be as different from each other as chalk and
cheese.
The exact differences, you don’t need to know, which
is just as well. So let’s concentrate on the main points:
DON’T SELL ME SHORT!
The ability of a hedge fund manager to bet on the price of
an investment falling is its most significant characteristic.
The practice is known as ‘short-selling’, and it works like this.
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Hedge fund
manager Flash
Harry thinks
that British
Airways is in
for troubled
times. His
suspicions were first
aroused because rising
oil prices are proving
very expensive for its
gas-guzzling aeroplanes.
Then, after the cancellation
of flights and general chaos
at Heathrow Airport in August
caused by strike action by food
supplier Gate Gourmet, he
becomes convinced BA’s share price
will fall over the next two months.
So he borrows 100,000 BA shares
from a professional lender and agrees
to give them back in two months’
time. As soon as he gets them, he
sells them – at 280p each – for
£280,000. Then he waits.
Five weeks later, he thinks the
price of BA shares have fallen as
much as they are going to over the
two-month period, and he buys
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GUIDE TO INVESTMENT: HEDGE FUNDS
100,000 shares at 200p each for £200,000. At the end
of the two months, he returns the 100,000 shares to the
lender having made a cool £80,000, less the £1,000
borrowing cost.
Sound easy? It does when you get it right and hedge
funds can be very profitable, particularly when prices
are falling across the stock market, like they were
in 2002.
FLASH IN THE PAN
But what if you get it wrong? Suppose our hedge fund
manager Flash had his wires crossed. A week after
borrowing, and selling the 100,000 shares, oil explorer
Shell reveals it has found a massive new reservoir of oil
under the North Sea, while Iraq becomes politically stable for the first time since the war after agreeing its first
ever
constitution. Result: oil prices plummet.
A week later, with flights and food restored to normal,
BA reveals that the amount of money it lost during its
week of chaos in August was pittance in comparison with
the amount it made through cheap online ticket sales
and the amount it is going to save in cheap fuel. Result:
its share price starts rising.
What does Flash do? He’s got six weeks to give back
100,000 shares he no longer owns and the price is going
up by the day. Still thinking BA is on borrowed time,
Flash decides to wait until the last minute to buy back
the shares, hoping the price will fall: but it doesn’t and
he is forced to buy them when the price has risen to
400p each.
At the end of the two months, Flash finds himself
nursing a loss of £120,000: not a pretty sight.
The problem is that there is no limit to the amount
Flash can lose by short-selling – BA’s share could have
risen in value by 500% or more. If Flash makes three
bad calls like this in a row, he could find his hedge fund
bankrupt and his investors left with nothing. This is what
newspapers mean when they say a hedge fund has
‘blown up’.
By comparison, imagine the worst case scenario for
your UK equity portfolio. In 2002, among the worst years
on record in the stock market, you might have lost 25%.
In the 1929 Wall Street crash, investors lost 32% in six
days. In just a few months with Flash, you could lose
100% with no chance of getting it back.
This is why trustees are anxious about investing in hedge
funds. It is their job to safeguard members’ pensions, not
act like a roulette wheel addict on a free trip to Las Vegas.
There is also the question of borrowing, or ‘leverage’ as
the industry calls it.
BOOM OR BUST
Flash thinks he is great. In fact, he is so confident that
for every £1 investors give him, he borrows £1 from a
bank and invests that too. Instead of borrowing 100,000
BA shares, he borrows 200,000 shares. If he gets it right
he doubles his profits – in this case £160,000. If he gets
it wrong he doubles his losses – here, £240,000.
Finally, hedge funds are almost always legally based in
sunny Caribbean holiday resorts like the Cayman Islands.
This is good news for the lawyers, who get an all-year
tan, and should be good news for investors too because
the Cayman Islands have the best regulation in the world
for hedge funds. But it can be a worry for trustees who
would feel an awful lot better about it if hedge funds
were regulated by the UK’s Financial Services Authority.
So why is everyone talking about hedge funds?
Firstly, the worst case scenarios above are misleading.
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While hedge funds can ‘blow up’, as Flash knows, this
happens rarely. BA’s share prices could go up by 40%
in six weeks, but this is extremely unlikely, even in the
exaggerated circumstances above.
Secondly, hedge funds do not borrow money without
strict internal controls and good reason. Most hedge
fund managers are investing their own personal money,
not just other people’s, so they take a great deal of care
over it.
And while they are not regulated in the UK, they are
regulated in the Cayman Islands, which is far more
sophisticated than you probably think. And at any rate,
hedge funds often self-impose strict controls that can be
more effective than London’s financial services police
ever has been.
Nevertheless, there is no question that giving 20% of
your pension fund’s money to Flash Harry would be risky.
When investing in a hedge fund, what you are essentially
doing is trusting the skill of the individual manager. And
even the best of us can get it wrong.
So what many pension funds are starting to do is
invest in portfolios of between 15 and 50 hedge funds,
to protect against the risk of one of them doing really
badly, or even blowing up.
And because hedge funds are all so different from
one another – and from other investments like property,
bonds or even the stock markets – investing in a good,
broad range of hedge funds can provide you with
regular profits irrespective of what is happening in the
rest of your investment portfolio, or indeed the rest of
the world.
SOME TYPES OF HEDGE FUNDS
Long/short equity
The most common type of hedge fund, long/short equity funds invest in the stock
markets like normal equity managers, but also ‘short-sell’.
This means that they invest in shares they think will go up in value, and ‘short-sell’
those they expect to fall in value. It is a powerful combination of skills that allows
managers to make money whatever the economic outlook.
Market Neutral
These funds are similar to long/short equity funds in that they can both buy-andhold shares in the stock market and ‘short-sell’. But they do this in a systematic way
such that if the entire market goes up, or down, their portfolio remains unchanged.
This is normally done buy buying shares in one company, and short-selling a similar
company so that the economic factors that effect prices in both are cancelled out.
They could, for instance, buy shares in Shell, and short-sell BP. Then if oil prices go
up or down, they remain unaffected overall.
Merger Arbitrage
When one company announces plans to buy another, typically its share price will go
down in price as the deal nears completion, while the share price of the company to
be acquired goes up. So the merger arbitrage hedge fund buys shares in the company
targeted, and short-sells the other. Of course, if the deal does not go through...
Event Driven
Mergers are not the only corporate transactions that affect the share price of
companies. Companies in financial distress or about to make major deals can see
their share price make predictable movements, and event-driven hedge funds aim to
capitalise on this.
Fixed Income Arbitrage
Its not all just about the stock market, hedge funds can make careful studies of the
fixed income bond markets to spot tiny discrepancies in prices. They then buy and
hold or short-sell, just like shares.
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Most popular are ‘funds of hedge funds’ which have
been shown to be a comfortable, low-risk way of getting
involved in the profitable world of hedge funds.
In a ‘fund of hedge funds’ the manager you hire has
the job of picking out the best hedge funds, making sure
they continue to do well and monitoring them to make
sure they are not taking too many risks.
This is a tough job, and not one you can do yourself
unless you have an unusually large and well resourced
pension fund. Trying to understand a hedge fund is a
lengthy, complex process even for an expert. And making
sure they reveal exactly what they are up to can be
tougher still.
The box on the previous page is a list of the different
types of hedge fund that your manager will pick between.
The manager will aim to invest in a few examples of each
‘strategy’, and will quickly drop any Flash Harry who
starts changing their strategy or making rash decisions.
The end result should be a portfolio that makes you
around 5% a year in profit. And this is where it gets
good: over 20 years or more a ‘fund of hedge funds’ can
make as much money as the stock markets, but with
much less risk!
HOW CAN THIS BE?
To answer this, we need to think about what we mean
by ‘risk’. When you invest in the stock market the biggest
risk you face is of a stock market crash, or at least a
major fall. When this happens, there is little you or your
investment manager can do about it.
PERFORMANCE SINCE 1987
1987-2004 average
annual return
1987-2004 standard
deviation
Funds of hedge funds (Hennessee Hedge Fund Index)
14.94%
10.77%
Stock markets (S&P500)
11.88%
17.53%
7.34%
4.95%
Average annual
return since 2001
Annual standard
deviation since 2001
Bonds (Lehman Bond Index)
Source: Hennesse Group
PERFORMANCE SINCE 2001
Funds of hedge funds
Stock markets (S&P500)
Bonds (Lehman Bond Index)
5.50%
3.10%
-0.64%
4.49%
8.38%
2.14%
Source: Edhec-Risk Asset Management Research
But when the stock market falls, a hedge fund manager
who is ‘short-selling’ is in their element. By contrast, the
risk you face in a hedge fund is that the manager makes
a few really bad judgements.
A UK equity portfolio, no matter who manages it,
will go up and down in value in line with stock markets.
A fund of hedge funds will, on the other hand, go up
and down much less, because you are investing in a
broad spread of managers who can make money in a
wide variety of circumstances: and if the right balance
of skilled hedge funds have been chosen, almost always
more get it right than get it wrong.
If you are not convinced, have a look at the figures
above. The US-based Hennessee Group has been
studying hedge funds since 1987, and according to their
calculations, a representative sample of hedge funds
very similar to a typical fund of hedge funds would have
made more money than the US stock market, with a
much lower standard deviation, over the last 17 years.
Standard deviation is a calculation of how much the
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value of your investments would go up and down, month
by month. So that makes a fund of hedge funds more
profitable and more reliable than the world’s leading
stock market.
More recent analysis bears this out. According to
French research company Edhec, funds of hedge funds
have on average returned 5.5% a year to investors since
2001, with a standard deviation of 3.1%, compared
with annual returns from the Standard & Poor’s 500
Index of 0.6% a year and a standard deviation of 4.5%.
FEES
But it is not all good news, and there are other concerns
trustees need to be aware of before reaching for the
phone book and looking up ‘hedge’.
Firstly, the dark cloud that is fees: hedge funds do not
come cheap, and this puts many trustees off completely.
Typically a hedge fund will charge you 2% a year of
your assets, a fund of hedge funds will take an additional
1% a year on top, and for every 1% made in profit, the
hedge fund manager will take an further 0.2% in what is
known as a performance fee.
The best managers only charge a performance fee
when they have made more of a profit than a bank
account would, but some do not. And it’s still pricey
even then.
These days there is also the problem of finding a good
manager. In what is considered the definitive survey of
hedge funds this year, accountancy firm KPMG found
that only 15% of hedge fund managers are ‘stars’ that
make really good profits, 55% are ‘wannabes’ who have
just started up and 30% are ‘has-beens’ whose best
years are behind them.
So the Yellow Pages may not be the best solution and
even a fund of hedge funds manager may struggle to find
enough quality hedge funds for your money. Note also
that hedge funds can only handle so much cash and
many of the best have been closed to new investors for
some time.
Huge amounts of money have been invested in hedge
funds in the last two years, which in turn has encouraged
the number of hedge funds to explode.
Some experts fear that as yet more money flows in,
the strategies that hedge funds use may become overused and returns will decline. This does not seem to
be happening yet, but it may do in the next five years
and it is worth contemplating.
Watson Wyatt’s investment consulting division estimates
that only 5% to 10% of hedge fund managers are ‘highly
skilled’ – so that means there are just 300 to 600 of
them worldwide.
This would mean that there is currently only at most
$150bn of ‘spare capacity’ among the top managers.
But in 2004, the hedge fund industry attracted $250bn
of new money.
This makes the task of a fund of hedge funds
particularly difficult – can they find enough room in
good hedge funds to invest in? ■
FOR FURTHER READING
Hedge funds: a catalyst reshaping global investment
KPMG, http://www.kpmg.com/
Edhec-Risk Asset Management Research
http://www.edhec-risk.com/
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