By Andrew Capon of World Equity magazine, from an interview with G. P. Van,
Chairman of Van Hedge Fund Advisors, Inc.
Leading hedge fund consultant and investor, G.P. Van, the chairman and founder of Van Hedge Fund Advisors (VAN)*, has conducted ground-breaking research into the long-term performance and characteristics of hedge funds. Here he explains that the results have significant implications for mainstream institutional investors.
The continuing growth of US and offshore hedge funds has been startling. However, the funds and their managers remain largely an enigma. The investing community’s view of hedge funds has been formed by the media’s occasional distant sighting of a Soros or Robertson causing ripples on the world markets.
But Soros and Robertson are as representative of the hedge fund world as elephants are representative of the animal kingdom. The hedge fund world is every bit as varied and colorful as the fauna of the earth. In addition to the highly visible pachyderms, the hedge fund world also has its hares, its turtles, its lions, its vultures, and – yes – its victims.
Penetrating this jungle is not easy. The US Securities and Exchange Commission (SEC) has a strict prohibition against hedge fund advertising. When a leading financial newspaper recently ran a directory of hedge funds, the SEC showed signs of clamping down. Even the most comprehensive of directories only touches the surface of the pool of talented managers out there.
For example, of the 30 or so managers (out of 1,300) which VAN would consider most desirable for an institutional investor, most have never appeared in directories, nor have they received media coverage – notwithstanding in many cases amazing consistency and attractive returns.
Faced with the huge diversity and numbers of hedge funds and the lack of solid information, mainstream institutional investors have tended to shy away from these managers. Research conducted at VAN shows this to be a missed opportunity.
VAN, working with faculty members of the Owen Graduate School at Vanderbilt University, has compiled a database of hedge fund performance that has enough depth of data to produce statistically-valid information on hedge funds as an asset class. The fund performance database contains over 800 US hedge funds with assets of approximately $32bn and over 500 off-shore funds with assets of approximately $48bn.
The headline performance figures are important. These show that hedge funds on aggregate comfortably outperformed both the MSCI World Index and the S&P500 for the five and seven-year periods. This was achieved with a lower Risk of Loss (ROL), which is defined as the probability of an investment achieving a zero or negative return of any magnitude over four rolling quarters within a defined time period.
Within the aggregate numbers individual styles of hedge fund have wide variety of performance. Distressed securities returned 21.5% annually, or more than double the S&P 500 with less than one-fourth of the ROL. Even though they were mauled in 1994, macro-funds such as Soros’ Quantum, Robertson’s Tiger and Cooperman’s Omega, also achieved 16.9% compound return over the last five years with a better ROL number than the S&P500.
Interestingly, styles of management that have traditionally been more appealing to institutional investors actually fare rather poorly by comparison. Market neutral arbitrage strategies have been regarded as low beta, safe route to excess market return. The fact that these strategies usually involve long convertible bond positions, with the downside-risk protection this affords, and a corresponding short in the common stock, has been attractive. However, though these strategies do just beat the market over five years (12.5% CAR compared with 8.7% for the S&P500) they do so with a relatively high ROL of 17.5%.
The overall performance picture of hedge funds remains a very healthy one. That is particularly true in market corrections. Though it would be foolish to suggest that hedge fund managers today slavishly follow the truly hedged $50 long/$50 short pioneering investment style of A W Jones (whose claim to history is that he was the very first hedge fund manager) neither are they the rabid speculators often depicted. ‘Hedging’ remains an important characteristic of the funds, as their performance in correcting and bull markets show.
In the six quarters since December 31, 1989 in which the S&P500 has been negative, the net returns of the average hedge fund exceeded those of the average equity mutual fund in every period. While investors in the average equity mutual fund lost 24%, and those in the average taxed income fund lost 3.1% over the same negative S&P quarters, investors in the average hedge fund gained 1%.
This demonstrates that hedge funds do what they say they should, provide hedged performance. That is also demonstrated by hedge fund performance in years of heady bull markets. On aggregate hedge funds do not participate fully in upward price movements. In 1995, the Van Global Hedge Fund Index is up only 10.3%, compared with the S&P500’s return of 24.1%, through July 1995.
At the level of individual funds the performance available to investors remains impressive. VAN has identified funds with compound annualised rate of return in excess of 20% and no losing years, for both the five and seven-year time periods (see chart opposite). Hedge funds also compare very favourably with mutual funds.
A recent study by VAN compared the quarterly returns of all US hedge funds having quarterly returns between 1990-1994 inclusive (230 funds), from the VAN database, with quarterly returns of all Morningstar equity funds with quarterly returns for the same period (1,917 funds). Net annual returns of the average equity fund exceeded those of the average equity mutual fund by 76%. The average hedge fund returned 13.2% net annually compared with 7.5% return from the average equity mutual fund.
The top 20 individual hedge funds produced net annual returns of 33.8% on average, compared with 21.9% for the top 20 individual equity mutual funds. The top 10% of hedge funds returned 33.3% net compared with 14.7% for the top 10% of equity mutual funds. The top 25% of hedge funds returned 24.6% net to their investors compared with 11.7% for the top 25% of equity mutual funds.
This barrage of relative performance statistics should convince even the most hidebound sceptical institutional investor in traditional assets that hedge funds are worth a second look. However, to be truly respectable hedge funds must overcome the great shibboleth of modern portfolio theory: correlation. If hedge funds do not diversify an institutional investor’s overall portfolio, then they are unlikely to prove attractive.
As the chart shows, the overall correlation of hedge funds as measured by the VAN index to the S&P500 and the MSCI World Index is relatively low (0.718 for the S&P and 0.538 for the MSCI). The correlation depends very much on the style of management. Styles with low correlation include market neutral, short selling (which is negatively correlated) and distressed securities. Styles with higher correlation include value and aggressive growth.
This lack of correlation should not be suprising. Hedge fund managers and their investors are interested in absolute rates of return. They are not bound to the game of beating relative return benchmarks, such as the indices by which mainstream investors judge the performance of their managers. Consequently, hedge fund managers are much more likely to make leveraged or highly concentrated bets on stocks, rather than the quasi-indexed positions often adopted by traditional money managers.
The effect of the addition of hedge funds to a traditional portfolio is illustrated by the efficient frontier. Since hedge funds, in aggregate, provide both better return and risk than traditional assets, it is not surprising that the characteristics of a traditional portfolio are improved by adding hedge funds. The traditional balanced portfolio is composed of the average return and risk characteristics of 60% of the S&P500 and 40% of the risk and return of the Lehman Brothers Aggregate Bond Index.
In quantitative terms, hedge funds generate alpha (excess return), rather than relying on the beta of the market. Using a portfolio optimising software program, the efficient frontier produced tells its user to dump traditional assets. The optimum allocation suggested by the optimiser, in this case, would be 80% hedge funds and 20% traditional assets. Naturally, that sounds excessive and would possibly frighten institutional investors who may prefer to set an arbitrary limit.
Between 20% and 30% of an overall pension fund portfolio would be a more measured introduction to the world of hedge funds. One possible route would be to buy into a fund of funds. These provide good diversification, with an average correlation to the S&P500 of 0.230. Another alternative for lower fees is to seek the advice of one of the specialist consultants.
Hedge funds have traditionally been shrouded in mystery. Now the veils are being lifted. What emerges is not a monstrous group of megalomaniac speculators intent on destabilising currency, stock and bond markets. Rather, a group of talented investors who deserve the attention of the broader institutional investment community.