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Hedge Funds As An Asset Class

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Hedge funds, long the unknown preserve of the super rich, have been making lots of news lately. Ever thought about becoming a hedge fund manager like the big boys? Well, conceptually at least, it’s not that hard.

Market-Neutral Hedge Fund
Let’s suppose that you and your buddies are really into cars. One afternoon you visit the showrooms to see the new models. You and the gang get really turned on at General Motors. There is excitement in the air. You conclude that GM’s new Rocket line will blast off. Meanwhile, over at Ford not much is happening. The guys all agree: Ford’s new Solar Explorer looks more like a misguided missile. Based on this extensive market research, you know that GM will do better than Ford. You hurry to call your broker. You buy $1,000 worth of GM stock, and sell short $1,000 of Ford. Congratulations, you are now a hedge fund manager!

What have you accomplished? You now have a pure play on the relative performance of GM and Ford. You have “hedged” away all general market risk. Your strategy is “market neutral.” If the market goes up, you will profit from your GM position, but the value of your short position will decline an equal amount. If the market goes down, the position is reversed. Disregarding transaction costs, as long as GM does relatively better than Ford you are going to make money. As a bonus, the short sale of the Ford stock frees up funds that can be invested in Treasury bills. So far, there is nothing particularly risky about your strategy.

Leveraged Market-Neutral Hedge Fund
You are so sure that GM will outshine Ford that you now decide to margin your account—that is, you are borrowing money with which you will buy stocks. You now are running one of those legendary leveraged hedged funds.

Highly Leveraged Market-Neutral Hedge Fund
Seeking ever-higher returns and oblivious to the risk, you decide to dispense with the stocks altogether and buy options instead. You now stand at the pinnacle of the financial world, having devised a market-neutral, highly leveraged, derivative hedge fund. George Soros is hearing footsteps! You have become one of Tom Wolfe’s Masters of the Universe. From your lofty perch, you observe more ordinary mortals, sure that nothing can go wrong.

Unfortunately, your marketing survey is flawed. You forgot that you and the gang are all middle-aged men. The kids are drooling over Ford’s muscle cars, while your wives are longing for the conveniences and styling found in Ford’s new minivans. GM is about to endure a very painful strike. Ford, the largest auto producer in Europe, will benefit from the turnaround in the economy there. Two Wall Street analysts recommend Ford, and the Heard on the Street column in The Wall Street Journal discusses an upcoming major lawsuit against GM’s truck division.

The market and Ford both remain unchanged, but GM drops $1 a share. Dreams of uncountable wealth evaporate. In a heartbeat, your position is wiped out.

You and the gang decide to take in a basketball game. The Knicks are on a hot streak. Maybe there is still time to call your bookie!

A brief tour of the landscape
Hedge funds have been around since 1949 when Alfred Winslow Jones developed the idea of a market-neutral strategy. The big attraction is the possibility of returns totally independent of market performance. In such a strategy, returns, if any, will be essentially random, and so have zero correlation to any other asset class. This characteristic qualifies hedge funds for consideration in our series as a separate asset class.

Most hedge funds are the market-neutral type. However, Dion Friedland describes 14 different strategies that hedge funds might employ that run from ultra conservative to extraordinarily high risk. For a fascinating primer on the subject, see his articles at the Magnum group’s web site.

Investing in any type of hedge fund is a big bet against the efficient market. For instance, almost the entire risk in market-neutral funds revolves around the manager’s stock-picking ability. If enough longs don’t go up, and enough shorts go down, the return will be negative.

Furthermore, evidence to support the thesis that stock-pickers can identify either over- or underpriced stocks consistently enough to cover the trading expenses involved in the effort is in exceedingly short supply. This problem does not go away in the rarefied atmosphere of the hedge funds.

Comparing the performances of hedge funds is difficult. Most hedge funds are private partnerships; many are offshore and thus unregulated by the SEC. The most authoritative work in the field is Offshore Hedge Funds: Survival & Performance 1989-1995by William N. Goetzmann, Roger G. Ibbotson, and Stephen J. Brown. They found “high attrition rates of funds, low covariance with the U.S. stock market, evidence consistent with positive risk-adjusted returns over the time, but little evidence of differential manager skill.” In other words, sure, theyre great diversification vehicles, but trying to pick a manager who can do it consistently well is a crap shoot. Tracking investor returns was complicated by severe survivorship bias: Only 25 of the original 108 funds survived the six-year period of the study! Investor returns were not available in the year a partnership was merged, terminated, or went bankrupt.

Everyman’s hedge fund
When last year’s tax act eliminated the “short-short” rule that had capped the limit for mutual fund earnings from short-term gains at 30%, it opened up the possibility for funds to ape some of the hedge fund practices.

The Barr Rosenberg Market Neutral Fund was the first to launch in mutual fund form. In practice, Rosenberg goes far beyond our simple GM/Ford example. The fund carefully balances many long and short positions across segments and industry sectors. So, it comes down to stock-picking skill. If being the smartest guy in town and crunching enough numbers will “beat the market,” then Rosenberg has about as good a chance as there is. But it’s tough to beat Mother Market, and investors must realize that even if everything goes just right, they may earn only a few more percentage points than what T-bills offer. The fund carries a 2.5% expense ratio, huge turnover and trading expenses, and you can count on all gains being taxable as ordinary income.

My chief problem with the market-neutral strategy (aside from the issue of market efficiency) is that while the risk is probably low, without the positive expectations that markets bring, returns will be problematic. By hedging away the market risk, market-neutral strategies give up the strong total returns that are embedded into capital markets. Over time, market returns alone bail out all but the most inept and unfortunate managers. So, from my viewpoint, a strong opportunity cost issue overrides the diversification benefit.