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Hedge funds in portfolios
Guidelines for hedge fund inclusion

Traditional money managers base their careers on the assumption that their ability to pick good stocks (or bonds) can add value. Adding value for a traditional manager means picking stocks that generate a rate of return high enough to cover the fees charged, while netting the investor a little extra return on top of popular stock indexes. While the merits of traditional managers are in perpetual debate, hedge fund managers would argue that they have much greater potential to add value. In this, the final installment in this four-part hedge fund series, I'll summarize past performance and provide a guide to portfolio inclusion.

Historical performance

Last week, we discussed how past hedge fund performance is biased upward. With that in mind, I will present to you a couple of key points regarding U.S. hedge fund.

I studied more than twelve years of U.S. hedge fund data (from January 1990 through March 2002) as compiled by Hedge Fund Research. My quantitative research began with two main questions in mind.

1. How have hedge funds performed, both in up and down markets compared to U.S. stocks (as represented by the S&P 500 index)?

While most hedging strategies studied had their worst losses at the same time (August 1998) as the S&P 500, most fell by considerably less. Those strategies that are most resilient during softer times for stocks are those with minimal exposure to the stock market - i.e. market neutral; convertible arbitrage; and relative value strategies fared best in down months for stocks.

Further, most hedging strategies have exhibited less downside risk than the index - when considering both the frequency and magnitude of losses.

2. Did hedge funds add value, in excess of the white hot U.S. stock market over the twelve years studied?

Value added in an academic context is measured by a statistic known as alpha. Without getting too technical, alpha looks at the out- or under- performance of a manager relative to some benchmark (such as the S&P 500), but does so in the context of how much exposure to the benchmark the manager had over the measurement period.

One of the cornerstone theories in investment management says that a U.S. stock manager's expected return is directly tied to how much exposure that manager has to the S&P 500, the most common benchmark for such managers. In other words, money managers investing entirely in the U.S. market should, over time, expect to earn no more than the return of that market. The theory says that, over time, managers will have a tough time adding value.

To better understand, a short illustration using dedicated short sellers may help. Traditional U.S. stock managers will invest entirely in U.S. stocks, effectively betting that the stocks they choose will eventually go up in price. Short selling hedge fund managers undertake strategies whereby they make bets on specific stocks they expect to fall in price - the antithesis of the traditional stock picker. In theory, traditional managers have market exposure equal to 100 per cent; while short selling strategies should have market exposure equal to about minus 100 per cent.

If "the stock market" returned 10 per cent over a period of time, this theory would expect the traditional manager to earn just about 10 per cent. But since the short seller is making exactly the opposite types of bets, the theory would expect a return of negative 10 per cent. If the short seller attains a return better than negative 10 per cent, alpha will consider the short seller to have "added value" despite the negative return (i.e. positive alpha).

My research found that most hedging strategies "added value" in the past.

Just keep in mind that all of these numbers have potential biases and that they are for category averages of the nearly 2000 funds tracked by Hedge Fund Research.

Hedge fund selection and portfolio inclusion
What you should take from this analysis are the following points:

  • Hedge funds are very unique and offer good upside potential. However, despite their glamour and recent mainstream acceptance, they're not immune from capital market risk.
  • Most hedging strategies have much less stock market exposure than most traditional stock mutual funds; but have generated higher risk-adjusted returns. While this was the case in the past, my figures are for hedge fund "averages". Many individual funds will not be worthy of your investment dollars. This point can't be stressed strongly enough. As a result, any hedge fund exposure might be best achieved through a fund-of-funds approach.
  • While the data show better risk adjusted returns than traditional stock indexes, these figures are likely biased in favour of hedge funds due to some of the implicit biases in the reported data (as discussed last week).
  • Many hedge funds are best used in tax-deferred accounts (i.e. RRSPs, RRIFs, etc.), where feasible, due to the resulting high levels of taxable income.
  • Hedge fund allocation is best defined as a percentage of an investor's equity weighting. A maximum of 20 per cent or so of an investor's equity weighting is a decent rule of thumb. So, if your target mix is 50/50 in stocks/fixed income, this guideline would tell you to put absolutely no more than 10% in hedge funds.

    Hedge funds aren't for everybody, but hopefully this series of articles makes you more informed before jumping into this popular class of funds.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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    Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...