UK: Hedge Funds: Time To Exit Or Do They Still Have A Place?

Last Updated: 12 April 2016
Article by Paul Wiseman

The violent intra-day market volatility seen in the past two weeks has caused widespread panic and has undoubtedly seen many investors making irrational and emotionally-driven decisions.

These decisions are often sub-optimal and result in the destruction of wealth for the investor. It is times like these when hedge funds can prove their worth by protecting investors against the full extent of the losses experienced by their long-only counterparts. The relative flexibility of hedge fund strategies also allows them to capitalise on the opportunities brought about by these extreme market movements and the conversations we've had with hedge fund managers in the last few days certainly speak to the resilience of these products in volatile times. Paul Wiseman, Senior Investment Analyst with Maitland in London, explains why hedge funds still very much have a place in investment portfolios – and even more so in the light of recent events.

Recent years have seen meagre returns relative to equities for the average global hedge fund, while most cheap and cheerful index trackers have produced solid gains. As a result, for those investors who have carried allocations to hedge fund strategies in place of more traditional asset classes, the role of hedge funds has come into question. These concerns are driven largely by the relative underperformance and the ongoing debate over excessive fees in the hedge fund industry. It ignores the fact that the inclusion of hedge funds in a particular portfolio may well be entirely the result of a desire not to have more traditional asset class exposure.

Performance fatigue

Indeed most criticism fails to address market exposure differences between hedge funds and long-only passive products. On average, hedge funds are neither fully exposed (beta of 1) nor are they fully hedged (beta of 0) to equity markets. It should therefore come as no surprise that hedge funds tend to underperform when markets rally strongly, and lose some money when markets sell off. Figure 1 compares hedge fund performance (HFRI Composite Index) to that of equities, fixed income and a generic, diversified portfolio of long-only assets over time. It is clear that there have been extended periods of out- and under-performance, and we are currently almost seven years into a sustained period of underperformance. The chart reflects the cumulative growth of a hypothetical US$ 100 invested in each of the asset classes listed. While hedge funds have outperformed over the very long-term, there are periods in between when other asset classes have performed better.

Figure 1: The long-term track record of hedge funds

Diversified portfolio is 60% MSCI World Index /40% Barclays Global Aggregate Bond Index

Source: Lyxor Asset Management

The decision to include hedge funds as part of a portfolio is often influenced by the type of investor in question. Certain investors, primarily ultra high net worth individuals, view hedge funds as high performance strategies that should outperform more traditional investments such as long-only equity or fixed income funds. Hedge funds charge high fees and are managed by some of the most talented people in the money management industry – and so it is fair enough to quickly come to a conclusion that hedge funds should be a pure outperformance product. But we think there is more to it than this.

Understand what you are buying

Hedge funds can play widely varying roles within a portfolio. They are often quite specific in nature and may often be used to fulfil a specific role in the portfolio construction process or to provide access to certain exposures, themes or ideas that are otherwise not possible within the more conventional approaches offered by long-only funds. As with any investment decision, its success or failure is assessed relative to the desired outcome. So what might these desired outcomes be if it is not simply about providing outperformance relative to long-only products?

Managing your downside risk

Whilst volatility is an imperfect measure of risk it is nonetheless a useful metric when appraising portfolio performance, particularly in comparing a portfolio's downside and upside volatility (that is, do you get more performance in up months than what you lose in down months?). The ability of hedge funds to short, use leverage and implement derivative structures means that hedge funds often tend to have low correlations to traditional long-only assets which can be comforting during turbulent periods for capital markets.

The combination of dampened volatility (be it downside or total) and low correlations is an attractive proposition for an investor considering their overall portfolio – adding such positions to a traditional portfolio willreducethe total risk of the portfolio but could increase or maintain long term returns.

The primary form of defence available to asset allocators faced with expensive asset or markets is to underweight these assets relative to a designated benchmark. This doesn't allow for the opportunity to directly benefit from a decline in the price of these assets, nor does it allow for the improvement in a portfolio's construction by adding uncorrelated positions. This is where hedge funds can be useful.

Consider the macro environment

While the last few years have been characterised by low volatility (in equities, fixed income and currencies) and low dispersion (that is most companies have benefitted from the wave of liquidity, irrespective of how well they have performed operationally) this benign environment cannot persist forever. The withdrawal of quantitative easing by the US Fed and the re-assertion of fundamental factors on asset prices should drive US markets back towards a state of relative normality. This process of adjustment is likely to create opportunities for those who are more flexible than their long-only counterparts.

Other central banks, most notably the European Central Bank and Bank of Japan, continue to ease monetary policy. This global divergence in monetary policy is a departure from prior years, where the central banks of the developed world were following expansionary policies, which creates opportunities particularly in the currency and fixed income markets. The opportunity set for relative value strategies looks a lot more attractive when assets are not all moving in the same direction.

Aside from the technical and macro perspectives, further opportunities exist due to activity in the corporate environment for event driven or merger arbitrage style managers. M&A activity has remained robust as financing remains cheap, corporate balance sheets are in a healthy condition and acquisitions are often accretive to earnings. This creates a fertile environment for further corporate activity.

Fees

For some, it is all about the fees, and nowhere is this debate more lively than with regard to hedge funds. We think the answer is simple – be very sure you are getting what you pay for. The relative performance versus volatility argument is even more relevant when you consider the fees you will be paying and what type of performance you are paying for. This is a substantive issue in its own right which merits further debate but the short answer is that investors should be most concerned with performance net of fees.

It isn't all about the upside

While on paper the returns generated by hedge funds over the last few years have lagged long-only strategies, it is important to assess these results in the context of the specific objectives from a total portfolio perspective. There are certainly a large number of hedge funds that have simply performed poorly, but don't ignore the others that have done what they said they would. Yes, hedge funds are more expensive investment vehicles but when skilfully selected and added to an existing portfolio, the long-term benefits can more than make up for the added cost.

Originally published on 01 September, 2015

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.