Are hedge funds, a form of investments journalists love to hate, worth a second look? Should your asset allocation include alternative investment such as Absolute Return funds into your portfolio?

Traditionally, any forms of investment other than cash, equities and bonds are considered as an alternative investment. That includes properties, commodities and hedge funds. Although classified in the same category, the difference in approach to investments for the alternative class as different as apples and oranges.

History of Hedge Funds

The first hedge fund was created by Alfred Winslow Jones in 1949. He employed leverage and short selling in the management of the fund and also pioneered the concept of performance fees, typically 20%, based on the positive performance of the fund. These features became the trademarks of hedge funds hence.

Hedge funds have its fair share of negative publicity and there have been occasional negative reports of hedge funds getting into trouble. While there are certain truths in the reports, behavioral finance may offer an explanation to the often negative impression of hedge funds.

Behavioral Finance Bias

Investors suffer from many behavioral biases. Availability and Confirmation bias are particularly pronounced when it comes to the bad press on hedge funds.

In displaying Availability biases, investors predict the frequency of an event based on how easily an example can be brought to mind. For example, the media will have widespread and extensive report on usual events like airline accidents compared to less coverage on car accidents. This is to be expected as the media depends on unusual and controversial topics to attract reader and viewership.

Confirmation bias comes into play when an investor displays the tendency to look for and favor information that confirms the initial impressions. Using the example of media reports of airline accidents, any new reports on airline accidents would catch the investor’s attention and ‘confirm’ his suspicion of the danger of taking flights after reading past reports. In truth, you are more likely to die on the way to the airport than taking the flight itself!

Hedge fund troubles are like airline accidents, there being extensive media coverage whenever something goes wrong.

The Promise of Absolute Return

Hedge funds attempt to deliver absolute return, that is, giving positive return in all kinds of market conditions without tracking any benchmark. A traditional actively managed long-only fund promises relative return and attempts to beat the index it tracks. A fund would have achieved this aim if for example it delivers 10% return when the index gave 8%. However, it too would have achieved its aim if it falls less than the index, for example, falling 5% when the index falls by 7%. Relative return would restrict investors to positive returns only when the market is positive. An absolute return approach could let the investor profit even during bear markets.

Due to the effects of compounding, an investment that delivers a constant positive return can beat the volatile investment that goes boom and bust. Table 1 shows the effects of compounding using two hypothetical portfolios.

A stable portfolio that gives a return between 5 to 7% per annum over five years can beat a portfolio that gives double digit returns over four years but suffers one major downturn. Just a single bad year might turn a portfolio negative!

Asymmetrical Return

Equities have rebounded strongly since the Financial Crisis in 2008. Stock indices with returns as high as 50% can be found in  2009. However, investors still find themselves facing a loss making portfolio.

Why? The reason is the asymmetrical return. As we can see from Table 2, a much higher growth is needed after a fall in value just to return to parity. A drop of 20% would need a 25% return to go back to square one. An 80% fall would need a 400% return!

The effects of compounding and asymmetrical returns are illustrated in Figure 1 which compares the return of two hedge fund indices and two equity indices from the start of year 2000 to end of 2014. The world witnessed great boom and bust during this period. The years from 2000 to 2003 saw the dot-com bubble burst, 911 terrorist attacks, Iraqi war and SARS. Equities then rallied from 2003 to 2007. The party ended with the Financial Crisis in 2008. In 2009 to 2010, world equities rallied again. The ten years from year 2000 to 2009 was called the ‘Lost Decade’ for world equities as the MSCI world gave no returns.

The value of absolute return approach was evident during the years when equities suffered (black box) as hedge funds outperformed. During the Financial Crisis, hedge funds too suffered losses, but the magnitude was much less severe compared to equities. Managed Futures, also known as Commodity Trading Advisers (CTA), was one of the best performing funds during the financial crisis with many rising up to 30%. During the boom years following the crisis, equities outperformed hedge funds.

Caveats

Hedge funds are not the panacea to investment risks. Like all investments, investors still have to be mindful of the risks.

Liquidity

Depending on the underlying strategy, hedge funds are generally not as liquid as traditional investments. During the Financial Crisis, some hedge funds implemented gating or suspension of redemptions. These measures might be for protection of the fund assets or other investors. A fire-sale during a crisis would only yield dismay valuations. This is similar to properties. Managed Futures do not suffer from poor liquidity due to the very liquid underlying futures market. Recent developments in regulations produced investable hedge fund indices with daily liquidity.

Non-diversified

Investing in any single company or asset can bring high returns but also higher risks. A company’s stock can go to zero due to mismanagement. A property investment can turn sour from buying at a market high. Investing into a hedge fund can also suffer from mismanagement or failed strategy. Investors can diversify away such risks by investing into fund of hedge funds or the above mentioned hedge fund indices.

Currency Risk

Most hedge funds invest in markets with matured capital systems that are found in developed markets. These funds are usually denominated is US Dollars or Euros. A Singapore investor using Sing dollars would face currency risk. A number of hedge funds have launched Sing dollar hedged classes to remove the currency factor.

Conclusion

Portfolio allocation looks to combine asset classes with low correlations to reduce risk and increase returns. Allocations to hedge funds with absolute return features can reduce portfolio risks and enable the investor to have better returns over the long term.

Disclaimers: Although every reasonable care has been taken to ensure the accuracy of the information contained in this article, the author cannot be held liable for any errors, inaccuracies, and / or omissions however caused. This article represents the personal views of the author and is for information only and does not constitute an offer or solicitation of any purchase. Any advice herein is made on a general basis and does not take into account the specific insurance and investment objective of any specific persons or groups of persons. The reader may wish to seek advice from a financial adviser before purchasing.