Are hedge funds a good asset class? May 2005

Donald Davidson investigates some anomalies and finds out the truth.

If you read the papers, hedge fund managers are risk-crazy gunslingers, greedy, evil geniuses capable of "breaking" the British pound (George Soros, 1992), or threatening the stability of the entire financial system (Long Term Capital Management, 1998). Indeed, hedge funds and airlines seem to suffer similar treatment: They get coverage only in the event of a disaster.

But, the fact is, hedge funds, as originally conceived, were intended to do just as their name suggests: to hedge, or dampen risk. (Sure, some hedge funds amp up on leverage, but many more aim to protect wealth, trying to hedge away risk by various diversification strategies.)

So, why the negative perception? Probably because hedge fund managers have become fabulously wealthy and are secretive (guiltily so), a body of untruths has sprung up. Of course, much of it is built on anecdotal evidence, oversimplification, myopia or simple misrepresentation of fact.

Myth 1: Investing in hedge funds is unethical.

The root of this myth is the "speculative" nature of some hedge fund strategies. Because their success depends upon the inexact science of exploiting market inefficiencies, all hedge funds have been tarnished and are viewed as risky - some might say reckless - investments. By extension, reps who would offer such investments can be viewed as acting imprudently or even unethically.

Nothing could be further from the truth. First of all, there are many kinds of hedge funds, some employing very conservative strategies. Secondly, if you take your job seriously at all, you realize that certain investors might actually minimize the risk of large losses provided by the diversification that hedge funds provide. This, in a nutshell, is what alternative investments like hedge funds are all about. In the context of a portfolio, risk is dampened by reducing a portfolio's share of volatile assets or introducing assets with low or negative correlation to the core of the portfolio. When risk to single hedge funds is diversified, large losses hardly occur, especially when compared with traditional investments that are essentially long on the asset class. What's so unethical about that?

Myth 2: Hedge funds are risky.

When examined in isolation, hedge funds (like technology stocks, energy trading companies or airline stocks) are risky. However, most investors do not hold single-stock portfolios. Everybody understands the concept of not putting your eggs in one basket. And so managers have been taught to create diversified portfolios with various kinds of stocks, bonds, and cash. It would be similarly unwise not to diversify with hedge funds either. Hedge funds offer an attractive opportunity to diversify an investor's portfolio of stocks and bonds. This is true even if the returns earned by hedge funds in the future are merely on a par with those of stocks and bonds.

Myth 3: Hedge funds are speculative.

This misunderstanding springs from the assumption that an investor using speculative instruments must automatically be running speculative portfolios. Many hedge funds use speculative financial instruments or techniques to manage conservative portfolios. Or, as hedge fund veteran Michael Steinhardt says "Hedge funds use speculative means for a conservative end." Not everyone understands this. Popular belief is that an investor using, for example, leveraged default derivatives (a financial instrument combining the three most unfortunate words in finance) must be a speculator. This is a misconception because the speculative instrument generally is used as an offsetting position. The reason for employing such an instrument is to reduce portfolio risk, not to increase it.

This is the reason why most absolute return managers regard themselves as more conservative than their relative-return colleagues. The decision of an absolute return manager to hedge is derived from whether principal is at risk or not. To him, "conservative" means preserving wealth. For a relative-return manager, the protection of principal is not necessarily a primary issue.

Myth 4: The lesson of LTCM is not to invest in hedge funds.

When Long Term Capital Management, which was rescued by the Federal Reserve, went belly-up in 1998, there were calls for more regulatory oversight and some of the more extreme advocated limiting access to such investment vehicles and even banning them outright.

But LTCM was not a typical hedge fund. In fact, LTCM's trading strategies were more in line with those of a capital market intermediary. So much so that LTCM viewed its main competitors as the trading desks at large Wall Street firms rather than traditional hedge funds. For this reason, using LTCM as a basis for generalizations about the hedge fund industry isn't appropriate.

Besides, no one suggests limiting access to the stock market or even shutting down the securities industry when a publicly traded company goes bankrupt and its stock becomes nearly worthless. It is generally understood that this is one of the slightly negative aspects of free markets and capitalism itself.

Myth 5: Hedge funds cause for worldwide financial panics.

There is increasing evidence that such blame is misguided. For instance, several research studies have shown that hedge funds did not cause the crash of the Malaysian ringgit, as suggested by the Malaysian prime minister Mohamad Mahathir, among others. Neither were hedge funds to blame for the 1992 European Rate Mechanism crisis, the 1994 Mexican peso crisis, or the 1997 Asian currency crisis caused by the devaluation of the Thai baht.

As we all know, capital reacts quickly to new information. So, when countries do something wrong - try to inflate their money, for example - capital flees. Nobody likes huge capital flight. However, the alternative to free flows of capital is almost always worse. If investors fear they will be unable to retrieve capital, investments will simply never happen in the first place.

In a surprise reversal of the time-honored tradition of vilifying hedge funds as perpetrators of global market calamities, the Monetary Authority of Singapore in January 1999 announced its intent to attract hedge funds. In a statement, a Singaporian Monetary Authority executive stated: "There are proprietary trading departments of perfectly respectable banks that punt the market. They are more damaging than hedge funds. Do we say 'no' to the banks then?"

The recognition of similarities between proprietary trading desks and hedge funds by regulators is positive. This recognition will likely reduce the risk that arbitrary and capricious legislation will be enacted to restrict the activities of hedge funds.

In 1994, George Soros was invited to deliver testimony to Congress on the stability of the financial markets, particularly with regard to hedge fund and derivatives activity. Soros believed the banking committee was right to be concerned about the stability of markets, saying: "Financial markets do have the potential to become unstable and require constant and vigilant supervision to prevent serious dislocations." However, he felt that hedge funds did not cause the instability. He blamed institutional investors, who measure their performance relative to their peer group and not by an absolute yardstick: "This makes them trend-followers by definition."

This, in a nutshell, summarizes the uphill battle of perception facing hedge funds. The sooner this battle is won, the sooner investors of all stripes can begin to embrace these useful instruments.

Donald Davidson is a financial journalist working in the US.