Transcript of "Hedge Funds: A Look Back and A Look Ahead - Dec. 2011"
Hedge Funds: A Look Back and a Look Ahead By Edward H. DeFrance and Michael J. Kelly SynopsisCRITICAL OBSERVATIONS: Hedge funds have proven to be• Including a group of broadly diversified hedge funds in a traditionally allocated portfolio worthy financial instruments over of stocks and bonds has been shown to potentially reduce portfolio volatility and the past 20 plus years, and have increase return. contributed to the growth of the• The investment environment for hedge funds going forward (2010 and beyond) could modern financial industry. The be attractive. Investment strategies that can make money in rising and falling equity addition of a well diversified group markets, such as those employed by many hedge funds, are better positioned for success of hedge funds to a traditional in an uncertain/volatile economy. portfolio has been shown to be an• Hedge funds and the interests of their constituents are better aligned now than they effective way to potentially increase were prior to 2008. returns, while also preserving capital• Due to the fallout of 2008 and the Bernie Madoff scandal, investors are assigning more during adverse market environments. value to the strength and integrity of a firm’s risk controls and procedures when conducting due diligence on potential hedge fund investments, as opposed to focusing While hedge funds have remained only on performance. somewhat of a mystery to the general public, and are often vilified by the• Investors are seeking better transparency, better liquidity, and more appropriate fee structures from funds. mainstream media (they were referred to as an “evil virus” in a 2005 Newsweek• Investors are requiring the use of independent, third-party services to support funds’ operations, manage custody of their assets and verify fund pricing. article for example), the reality is that many institutions and high-net-worth• Fund of hedge funds (FoHFs) will continue to be a major channel into hedge funds, providing more investors ease of access and exposure to a broad range of investment investors have invested in hedge funds styles and strategies, along with an additional level of risk management. for many years, and continue to do so as a means to add diversification to their portfolios. Going into 2010, the hedge fund industry appears to be healthier than it has been in more than a decade, albeit much smaller in terms of assets than it was at its peak two
years ago. While 2008 was without In 2009, investors are already starting doubt one of the most challenging to reap the benefits of this new investment environments we have hedge fund world order, as industry seen this century, the hedge fund returns appear to be on pace to industry emerged from the crisis reach 10-year highs. Looking ahead, case-hardened and remains a viable reduced competition and major compliment to traditional stock and macroeconomic trends could lead to bond investing. From an investment above average returns. opportunity standpoint, the landscape is attractive as many asset classes are A History of Success … offering substantial risk premiums and Misunderstanding? and competition has significantly “It is the nature of humans to diminished (with weaker, less- fear what it is they do not know qualified hedge funds closing in 2008, or understand.” fewer asset managers are chasing ~ Rod Serling, creator of similar trades – leaving more pie for The Twilight Zone the worthy survivors to share). Clearly, hedge funds have played an For investors, the most tangible important part in the expansion of positive outcome left by the shock of capital markets in recent years. Since 2008 has been a humbling of sorts for 1990, hedge funds have represented the industry. Many previously closed one of the fastest growing segments hedge funds have now opened their of asset management. The number doors to accept new capital, are much of hedge funds around the world more willing to be flexible on fees and exploded from 610 in 1990 to lock-up periods, and – perhaps most approximately 9,000 by the end significantly – are much more willing of 2008.1 Over the same period, to pull back the curtain and share industry assets under management information about their success. grew exponentially as well, from $39 billion to an all-time high of GRAPH 1: $1.9 trillion by the second quarter Total Hedge Fund Assets of 20082 (Graph 1). December 1990 through June 2009 Estimate For something that has grown so $2,100 $1,868 rapidly and become such an integral part of the global financial system $1,600 Hedge Fund Assets ($ billion) $1465 $1407 through the years, there is still a $1,100 $973 $1105 $1000 general lack of understanding about $820 the hedge fund industry. Indeed, it $626 $600 $456 $491 $539 is often surprising to those of us who $368 $375 $168 $167 $186 $257 work in the industry just how much $100 $58 $96 $39 misinformation is circulated, not 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) just among small investors, but even Source: HFR Global Hedge Fund Industry Report, second quarter 2009. Hedge Fund Research, Inc., at the highest levels of sophisticated August 2009, www.hedge-fundresearch.com institutional asset management. 240% 190% Bonds -2- Hedge Fundsive Return 140% Stocks
The confusion, and in some cases “Absolute” Returns Hedge Funds: A Primer controversy, over hedge funds is By design, most hedge funds are What is a hedge fund? likely a function of their private intended to provide consistent • he term ‘hedge fund’ refers to T structure. As opposed to a mutual positive returns regardless of the pooled investment structures fund, almost all hedge funds are direction of the broad markets, • edge funds may utilize a broad H private offerings because they are not utilizing a wide variety of financial array of financial instruments to sold publicly on open exchanges. instruments to do so. This approach generate performance Because of this, the Securities and stands in contrast to that of traditional • here are many types of hedge T Exchange Commission strictly limits managers, who measure themselves funds using many different the amount of information that in relative terms and are prepared to investment strategies can be shared about them with the accept losses in value, if those losses • ension funds, endowments, P general public. insurance companies, private banks, are less than a stated benchmark and high-net worth individuals and As such, many investors consider (such as the S&P 500 Index). families invest in hedge funds hedge funds highly risky, highly Hedge funds have, for the most part, aggressive and somewhat speculative • any hedge funds attempt to achieve M succeeded in achieving this goal positive returns in both rising and investments. Sensationalized hedge and in preserving capital during bear falling capital market environments fund blow-ups and frauds, like Long markets. From 1990 to 2008, the • he inclusion of hedge funds in a T Term Capital Management or the industry experienced only two down traditional portfolio is intended to Madoff scandal (see page 5) naturally years, weathering difficult periods add diversification, reduce risk and contribute to this misconception. like the Mexican peso crisis, the potentially increase returns While in some cases this is true, the Asian financial crisis, the collapse of • edge funds seek to maintain low H reality is that there are a wide variety correlations (definition on page 4) of different types of hedge funds, Long Term Capital Management, the with traditional assets classes (stocks each utilizing different levels of risk bursting of the dot-com bubble, and and bonds) and each seeking different types of the collapse of the credit markets in • ost hedge funds do not measure M $2,100 returns. Many hedge funds actually 2001-2002. From a performance $1,868 $2,100 themselves against traditional market $1,600 pursue very conservative strategies $1,868 perspective, hedge funds have been Hedge Fund Assets ($ billion) $1465 benchmarks (like the S&P 500 Index) $1,600 that target modest but consistent successful in achieving their objective $1407 Hedge Fund Assets ($ billion) $1465 but instead target “absolute” returns $1407 of providing consistent returns that $1105 $1,100 (positive performance regardless of returns and – above all – relatively $1105 $973 $1000 $1,100 low risk. $973 $1000 exhibit low correlation to the broad $820 the direction of the broad markets) $820 $626 $600 $600 $539 $626 $368 $375 $456 $491 $539 equity markets, while maintaining $456 $491 $257 $368 $375 $58 $96 $168 $167 $186 $257 low volatility (Graph 2). $168 $167 $186 $100GRAPH 2: $100 $39 $58 $96 $39 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09Hedge Funds at Work – Providing Consistent Returns 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) $(400) Cumulative Return and Value of $1 Million Investment October 1994 through September 2009 240% 240% 190% 190% Bonds: $1.91 million BondsBonds: $2.78 million Bonds Hedge Funds: Hedge Funds Hedge Funds: $2.52 million Hedge Funds $1.84 million Cumulative ReturnCumulative Return 140% 140% Stocks Stocks Stocks: $2.29 million 90% 90% All data is sourced from Pertrac. Hedge funds are 40% represented by the Edhec Fund of Hedge Funds Index. 40% Stocks: $1.31 million Global equities are represented by the MSCI World Equity Index. Bonds are represented by the Barclays -10% US Corp. IG Index. Please see page 11 for additional -10% information on data sources. 4 95 96 6 97 98 8 99 4 0 95 0 96 1 t 9 02 n 02 b 03 t9 4 4 Fe n 05 Oc 06 06 07 08 08 09 t9 t9 t9 t9b0 n t0 b 0 Oc b 0 Ju c t 0 n b n b n Fe Jun Oc Feb Ju O c t Fe un b ct 01n b 02t 03n 6 J7 Fe8 O8 J99 Fe0 00 0e2 04 4 05 06 6 07 08 8 09 Oc Oc Oc Ju O c t Oc Ju Ju Ju u u n Ju Fe Fe Oc Fe 9 9 0 tO t0 t0 t0 bF nJ n b b n b n b n Oc Oc Oc Oc Ju Ju Ju Ju Ju Fe Fe Fe Fe 14% 14% -3- Risk reduced by 28% 12% 11.6% Risk reduced by 28% 12% 11.6% Return Increased 10% by 3% Return Increased
Going Mainstream recently demonstrated an ability to Demonstrating success during the add value to a traditional portfolio 2000-2002 bear market, hedge allocation, by both enhancing returns funds essentially signaled their arrival and reducing risk (see Graph 3). to the world. What had been until Growth and Consequences then a vehicle that only the most $2,100 Correlation is a statistical measure of sophisticated and ultra-high-net- As a by-product of this surge in how two securities move in relation to investor appetite, industry assets worth investors were privy to – or $1,868 each other. Perfect positive correlation $1,600 interested in, for that matter – hedge under management grew Hedge Fund Assets ($ billion) implies that as one security moves, $1465 $1407 either up or down, the other security funds began garnering attention from substantially. From 2000 to 2008, $1105 $1,100 will move in lockstep, in the same other parts of the investor spectrum, $973 hedge fund assets expanded 20% $1000 direction. Alternatively, perfect negative most $626 $820 notably institutions and other per year,3 growing nearly four times $600 correlation means that if one security $456 wealthy investors. $491 $539 in size since 2000.4 There were some $368 $375 moves in either direction the $257 security negative consequences of this $100 $168 $167 $186 that is$58 $96 negatively correlated perfectly Institutions began seeking them out $39 exponential growth: transparency will move by an equal amount in the much more frequently as a source levels were not satisfactory, as 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) opposite direction. If the correlation is 0, of diversification and “absolute” investors often acquiesced to the movements of the securities are performance following on the stable said to have no correlation; they are manager’s preferences for secrecy; returns hedge funds had demon-% completely random. due diligence standards were often strated during the dot-com bust. compromised (as was clearly the Sustained low interest rates during% case for some feeder funds directing this period, coupled with a flat Bonds Hedge their clients to Madoff); and poor equity environment, also contributed Funds Stocks liquidity management practices% to this interest. From a performance emerged, high-lighted by the high perspective, a broadly diversified number of funds who gated their% portfolio of hedge funds has fairly investors in 2008.% Extreme growth also diluted the GRAPH 3: quality and skill of fund managers.% Hedge Funds at Work – Benefits to Traditional Portfolio Previously, hedge fund managers had been Wall Street’s best and brightest. 4 95 96 6 97 98 8 99 00 0 01 02 2 03 04 4 05 06 6 07 08 8 09 t9 t9 t9 t0 t0 t0 t0 t0 Impact on Risk and Return – October 1994 through September 2009 n b n b n b n b n b n b n b nOc Oc Oc Oc Oc Oc Oc Oc Ju Ju Ju Ju Ju Ju Ju Ju Fe Fe Fe Fe Fe Fe Fe 14% However by late 2006, anyone with a 11.6% Risk reduced by 28% financial calculator suddenly believed 12% Return Increased he or she was qualified to do the job. 10% by 3% 8.3% Annualized Volatility 8% 6.4% 6.6% Annualized Volatility (Risk) 6% (Risk) Annualized Annualized 4% Return Return 2% 0% Traditional Portfolio Traditional Portfolio with Hedge Funds (70% stocks, 30% bonds) (40% stocks, 30% bonds, 30% hedge funds) Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion versus the mean or experienced value: the higher the standard deviation, the greater the volatility. Please see page 11 for additional information on data sources. -4-